Gains & Losses
The IRS has finally provided a safe-harbor method to report gain or loss by taxpayers who are unable to complete a deferred like-kind exchange solely due to a qualified intermediary (QI) who defaults on its obligation to acquire and transfer replacement property. On March 5, 2010, the IRS issued Rev. Proc. 2010-14, which will not treat taxpayers as being in actual or constructive receipt of exchange proceeds if they cannot complete an exchange because of a default of a QI in bankruptcy or receivership.
Many taxpayers use a QI in like-kind transactions, where they will transfer the relinquished property to the QI, who will then sell the property to a buyer. The QI will take the proceeds of the sale of the relinquished property, buy the replacement property, and then transfer the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period required and meets the other Sec. 1031 requirements, he or she is considered to have engaged in a like-kind exchange of property with the QI and will not have to recognize gain on the exchange. But what happens when the QI cannot complete the transaction because the QI files for bankruptcy or is placed in receivership?
The IRS has been promising some type of relief for a long time. As far back as 2007, when the real estate market was starting to have problems, Representative Barney Frank (D-MA) asked the IRS to look into this issue. It was then that the IRS indicated that it was considering whether it was appropriate for it to extend relief where a QI was placed in bankruptcy. In July 2009, in response to a constituent of Representative Doug Lamborn (R-CO) who had a done a like-kind exchange with a subsequent bankrupt QI, the IRS said that where a QI fails to acquire replacement property and transfer it to the taxpayer within the statutory replacement period, a taxpayer cannot defer recognition of gain on the original transfer of the relinquished property under Sec. 1031. Accordingly, the IRS held that the taxpayer must recognize and report in income any gain realized on the disposition of the relinquished property through the QI. It also pointed out that a taxpayer would be entitled to a loss as a result of the QI’s actions, but only when that loss is evidenced by a closed and completed transaction under Regs. Sec. 1.165-1(d).
However, the subsequent loss would not help in most cases because it may not be recognized until several years later. Generally, the taxpayer would not be able to recognize loss under Sec. 165 until it received notice of the proceeds it would acquire at the conclusion of the bankruptcy proceedings. But the IRS sent information letters to Senator Christopher Dodd (D-CT) and Representative John Larson (D-CT), saying it was sympathetic to the plight of property owners left in a deferred-exchange bind due to QI bankruptcy. It again stated that it is reviewing the scope of its authority to issue administrative guidance in this area.
Background
In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is held either for productive use in a trade or business or for investment Sec. 1031. Under Sec. 1031(a)(3), for a deferred exchange to be treated as tax free, a taxpayer must identify the replacement property within 45 days of the transfer of the relinquished property and must acquire the replacement property by the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange or the due date (determined with regard to extensions) of the taxpayer’s federal income tax return for the year in which the transfer of the relinquished property occurs. Absent relief, if the statutory timing requirements are not met, a taxpayer would have to treat the relinquished property as having been disposed of in a taxable sale or exchange in the year it was transferred to the QI.
The regulations allow a taxpayer to use a QI to facilitate a like-kind exchange (Regs. Sec. 1.1031(k)-1(g)(4). When a taxpayer uses a QI, he or she generally transfers the relinquished property to the QI, which sells the property to a buyer. The QI then takes the proceeds of the sale of the relinquished property, buys the replacement property, and transfers the replacement property to the taxpayer. If the taxpayer receives the replacement property within the period in Sec. 1031(a)(3) and meets the other Sec. 1031 requirements, he or she is treated as having engaged in a like-kind exchange of property with the QI and will not recognize gain on the exchange.
Focus of Rev. Proc. 2010-14
Rev. Proc. 2010-14 basically allows a taxpayer that qualifies under the safe-harbor conditions to defer recognition of any gain from the original like-kind exchange until payment is received from the bankruptcy or receivership proceeding. A condition of the safe-harbor method is that the taxpayer must recognize gain on the disposition of the relinquished property under the enumerated gross profit method. There are specific rules covering situations involving satisfied indebtedness exceeding adjusted basis, recapture income, and imputed interest. What the revenue procedure does not do is give the taxpayer a way to still defer the gain from the original like-kind exchange by reinvesting in like-kind real estate. Eventually, when the taxpayer has received all it is going to receive from the bankruptcy or receivership proceeding, the taxpayer will realize either a gain based on proceeds received over its adjusted basis or loss if it does not receive proceeds over its adjusted basis.
Who Is Entitled to Relief?
A taxpayer is entitled to relief under Rev. Proc. 2010-14 if it:
- Transferred relinquished property to a QI in accordance with Regs. Sec. 1.1031(k)-1(g)(4);
- Properly identified replacement property within the identification period (unless the QI default occurs during that period);
- Did not complete the like-kind exchange solely because of a QI default involving a QI that became subject to a bankruptcy proceeding under the U.S. Code or a receivership proceeding under federal or state law; or
- Did not, without regard to any actual or constructive receipt by the QI, have actual or constructive receipt of the proceeds from the disposition of the relinquished property or any property of the QI before the QI entered bankruptcy or receivership. For purposes of this condition, relief of a liability under the exchange agreement before the QI default, either through the assumption or satisfaction of the liability in connection with the transfer of the relinquished property or through the transfer of the relinquished property subject to the liability, is disregarded.
The Safe-Harbor Gross Profit Method
A condition of qualifying for this safe-harbor method (and thus qualifying for deferral of the original gain attributable to the like-kind exchange) is to report the gain realized on the relinquished property as the taxpayer receives payments attributable to the relinquished property using the safe-harbor gross profit method described in Section 4.03 of Rev. Proc. 2010-14.
Under the safe-harbor gross profit method, the portion of any payment attributable to the relinquished property that is recognized as gain is found by multiplying the payment by a fraction, having the taxpayer’s gross profit as the numerator and the taxpayer’s contract price as the denominator. Important definitions under this method are:
- A payment attributable to the relinquished property means a payment of proceeds, damages, or other amounts attributable to the disposition of the relinquished property (other than selling expenses), whether paid by the QI, the QI’s bankruptcy or receivership estate, the QI’s insurer or bonding company, or any other person. Unless it exceeds adjusted basis, satisfied indebtedness is not a payment attributable to the relinquished property.
- Gross profit means the selling price of the relinquished property, minus the taxpayer’s adjusted basis in the property (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
- The selling price of the relinquished property is generally the amount realized on its sale, without reduction for selling expenses. But if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver specifies, by the end of the first tax year in which the taxpayer receives a payment attributable to the relinquished property, an amount to be received by the taxpayer in full satisfaction of his or her claim, the selling price of the relinquished property is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
- The contract price is the selling price of the relinquished property minus the amount of any satisfied indebtedness not in excess of the property’s adjusted basis. Satisfied indebtedness means any mortgage or encumbrance on the relinquished property that was assumed or taken subject to by the buyer, or satisfied in connection with the transfer of, the relinquished property.
A Sec. 165 loss deduction may be claimed for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of (1) the payments attributable to that property (including satisfied indebtedness in excess of basis) plus (2) the amount of any satisfied indebtedness not in excess of basis. Those claiming a loss deduction may also claim a Sec. 165 loss deduction for the amount of any gain recognized in accordance with this revenue procedure in a prior tax year.
Example 1: A, an individual who files his federal income tax return on a calendar-year basis, owns investment property (Property 1) with a fair market value of $2 million and an adjusted basis of $1 million. A enters into an agreement with Q, a qualified intermediary, to handle the deferred like-kind exchange. On June 6, year 1, A transfers Property 1 to Q, and Q transfers it to a third party in exchange for $2 million. A intends that the $2 million held by Q be used by Q to acquire A’s replacement property. On July 1, year 1, A identifies Property 2 as replacement property. On August 15, year 1, Q notifies A that it has filed for bankruptcy protection and cannot acquire replacement property. Consequently, A fails to acquire Property 2 or any other replacement property within the exchange period. As of December 31, year 1, Q’s bankruptcy proceedings are ongoing, and A has received none of the $2 million proceeds from Q or any other source.
On September 1, year 2, Q exits bankruptcy, and the bankruptcy court approves the trustee’s final report, which shows that A will be paid $1.8 million in full satisfaction of Q’s obligation under the exchange agreement. A receives the $1.8 million payment on October 4, year 2, and does not receive any other payment attributable to the relinquished property.
A is not required to recognize gain in year 1 because he did not receive any payments attributable to the relinquished property in year 1. A recognizes gain in year 2.
A’s selling price is $1.8 million, the payments attributable to the relinquished property (the amount specified by the trustee before the end of the first tax year in which A receives a payment attributable to the relinquished property). A’s contract price is also $1.8 million because there is no satisfied or assumed indebtedness. A’s gross profit is $800,000 (the selling price ($1.8 million) minus the adjusted basis ($1 million)).
A’s gross profit ratio is 800,000 ÷ 1,800,000 (gross profit divided by contract price). A must recognize gain of $800,000 in year 2 (the payment attributable to the relinquished property ($1.8 million) multiplied by his gross profit ratio (800,000 ÷ 1,800,000)).
Furthermore, even though the payment attributable to the relinquished property ($1.8 million) is less than the $2 million proceeds that Q received, A is not entitled to a Sec. 165 loss deduction because the payment attributable to the relinquished property exceeds his adjusted basis in the relinquished property ($1 million) (Rev. Proc. 2010-14, §4.10, Example (1)).
The finality of the initial notification of the bankruptcy plan proceeds will have an important impact on the recognition of gain and the related timing of that recognition.
Example 2: C, an individual who files federal income tax returns on a calendar-year basis, owns investment property (Property 1) with a fair market value of $1 million and an adjusted basis of $400,000. C enters into an agreement with Q, a qualified intermediary, to facilitate a deferred like-kind exchange. On June 6, year 1, C transfers Property 1 to Q, and Q transfers it to a third party in exchange for $1 million. C intends that the $1 million held by Q be used by Q to acquire C’s replacement property. On July 1, year 1, C identifies Property 2 as replacement property. On August 15, year 1, Q notifies C that it has filed for bankruptcy protection and cannot acquire replacement property. Consequently, C fails to acquire Property 2 or any other replacement property within the exchange period. As of December 31, year 1, Q’s bankruptcy proceedings are ongoing, and C has received none of the $1 million proceeds from Q or any other source.
On September 1, year 2, Q exits bankruptcy, and the bankruptcy plan of reorganization provides that C will receive $350,000 in October of year 2 in partial satisfaction of Q’s obligation under the exchange agreement. The bankruptcy plan also provides that, depending on various facts and circumstances described in the reorganization plan, C might receive a payment in February of year 3. On October 2, year 2, Q pays C $350,000. On February 3, year 3, C is notified that there will be no year 3 payment and that the $350,000 she received in year 2 represents full satisfaction of Q’s obligation under the exchange agreement. C receives no other payments attributable to the relinquished property.
C is not required to recognize gain in year 1. She recognizes gain in year 2. C’s selling price is $1 million (the amount realized by Q on the sale of the relinquished property) because, by stating that C might receive a payment in year 3, the bankruptcy plan did not specify by the end of year 2, the first year in which C receives a payment attributable to the relinquished property, the amount C would receive in full satisfaction of her claim.
Because there is no satisfied or assumed indebtedness, C’s contract price is also $1 million. C’s gross profit is $600,000 (the selling price ($1 million) minus the adjusted basis ($400,000)). C’s gross profit ratio is 600,000 ÷ 1,000,000 (the gross profit over the contract price). Thus, C must recognize gain of $210,000 in year 2 (the payment attributable to the relinquished property ($350,000) × (600,000 ÷ 1,000,000)).
In year 3, C is entitled to a Sec. 165 loss deduction of $50,000, the excess of her adjusted basis ($400,000) over the payments attributable to the relinquished property ($350,000). C is also entitled to a Sec. 165 loss deduction of $210,000 in year 3, the amount of gain that she recognized in year 2.
Effective Date of Relief
Rev. Proc. 2010-14 is effective for taxpayers whose like-kind exchanges fail due to a QI default occurring on or after January 1, 2009. A taxpayer who is within the scope of Rev. Proc. 2010-14 may, subject to the Sec. 6511 limitations on credit or refund, file an original or amended return to report a deferred like-kind exchange that failed due to a QI default in a tax year ending before January 1, 2009, in accordance with Rev. Proc. 2010-14.
With this revenue procedure, the IRS finally brings clarity to the timing issue of the recognition of gain and, if there is an economic loss, the recognition of that loss. However, given that the request for guidance and related relief was made over three years ago, the IRS will likely not get much recognition for the timeliness of this guidance.
Editor: Anthony S. Bakale, CPA, M. Tax.
EditorNotes
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.
