Miller Nash LLP
The IRS has provided some relief for taxpayers who had completed the first leg of an exchange, only to have the accommodator file for bankruptcy or be involved in a receivership. In Rev Proc 2010-14, the IRS ruled that in such situations the exchange will be treated as an installment sale.
In order to complete a tax-free exchange under Section 1031, the taxpayer must sell his or her property using the services of a qualified intermediary (also known as an accommodator). If qualified replacement property is properly identified within the 45-day identification period and it is actually acquired within 180 days, or the earlier due date of the taxpayer's tax return, the exchange qualifies for tax-free treatment under Section 1031.
But what if the accommodator files for bankruptcy in the interim? In that situation, many taxpayers have found themselves in the unhappy situation of losing some or all of their funds. But even if the funds were completely lost, they could not get access to the funds within the 180-day replacement period in order to complete their exchange.
The new revenue procedure allows the gain to be recognized similar to an installment sale. It requires the following: (1) that the accommodator be a qualified intermediary, (2) that the replacement property be properly identified unless the accommodator was in default before the end of the 45-day identification period, (3) that the like-kind exchange not be completed solely because of the bankruptcy of the accommodator, and (4) that the taxpayer not be in constructive receipt of the fund held by the accommodator before the bankruptcy filing.
The new procedure determines gain similarly to an installment sale under Section 453. The gain is recognized if, as, and when the accommodator ultimately distributes cash to the taxpayer:
Joe sold his $5 million building through an accommodator. His basis was $1 million. Joe was unable to acquire replacement property because Joe's accommodator had filed for bankruptcy. Joe's gain for a normal sale is $4 million. Joe is advised that he will receive $3 million in full satisfaction of his claim three years after the bankruptcy was filed and in that year receives $1 million in cash. Joe's gain for purposes of the calculation is $2 million ($3 million cash recovery less $1 million basis). His gain ratio is 67% ($2 million gain / $3 million sale price). Joe will have taxable income in the year he receives the first $1 million of cash of $670,000 ($1 million × 67% gain ratio).
If the taxpayer does not even receive enough cash from the bankruptcy to equal his basis, he will be able to claim a loss. Additional guidance is provided for many additional situations, such as for taxpayers who sold encumbered property.
The best approach for taxpayers is to use caution in negotiating the exchange with the accommodator. Make sure that the accommodator is adequately capitalized. Consider securing the accommodator's obligation with a qualified escrow or qualified trust arrangement. Oregon and Washington have each passed laws that provide new regulatory scrutiny of accommodators, but the new laws by no means guarantee that taxpayers cannot lose money in dealing with a financially unstable or dishonest accommodator.
Note that the new revenue procedure does not extend the 45-day identification period or the 180-day replacement period.
Ron Shellan is a partner at the law firm Miller Nash LLP. Miller Nash is a well established firm with strong traditions and fresh ideas. Serving the Pacific Northwest more than a century, Miller Nash lawyers are creative thinkers committed to serving clients and community in smart and innovative ways. You may reach Ron by phone at 503-224-5858 or e-mail firstname.lastname@example.org.