IRS Issues Final Regulations on Like-Kind Exchanges

July 10, 2008 | Roger McEowen



The IRS has published final regulations that address the treatment of funds that are used in deferred like-kind exchanges.  The rules contain new provisions on commingled accounts, administrative fees, and the applicable federal rates (AFRs).  The final regulations will impact taxpayers that engage in I.R.C. §1031 exchanges and escrow holders, trustees, qualified intermediaries and other that hold funds during a like-kind exchange.

Treatment of Loaned Funds

IRS had initially proposed regulations in early 1999 (even though they weren’t published until February of 2007).  Those regulations included a facts and circumstances test for determining who owned the assets in escrow accounts held during I.R.C. §1031 exchange transactions.  Under that test, the presumption was that exchange funds were loaned to the qualified intermediary, unless the qualified intermediary paid all the interest on the exchange funds to the taxpayer.  If the loan contained a below market rate of interest, interest was set at the imputed rate of interest equal to the AFR.  That treatment didn’t set well with some practitioners, but IRS generally stayed with loan characterization in the final regulations with some exceptions for small businesses.

General rule of loan treatment.  Under the final regulations, the general rule is that “exchange funds” are treated as loaned by a taxpayer to an “exchange facilitator.”  Exchange funds are – (1) relinquished property;  and (2) cash or cash equivalents that secure the obligation of the transferee to transfer replacement property held in a qualified escrow account, qualified trust or other escrow account, trust or fund.  An exchange facilitator is a qualified intermediary, transferee, escrow holder, trustee or other party that holds exchange funds for a taxpayer in a deferred exchange pursuant to an escrow, trust or exchange agreement.  The exchange facilitator must take all items of income, deduction and credit into account.  Interest is generally imputed to the taxpayer under I.R.C. §7872, unless the exchange facilitator pays sufficient interest.  The exchange facilitator has income from the imputed interest and offsetting deductions for the deemed paid interest.   

When loan treatment does not apply.  Loan treatment is inapplicable if the escrow agreement, trust agreement, or exchange treatment makes the earnings on the exchange funds payable to the taxpayer.  In that event, the taxpayer must take all items of income, deduction and credit into account.  The final regulations specify that the earnings attributable to the taxpayer’s exchange fund include only the earnings on the separately identified account.  Fees for administrative services are not treated as earnings attributable to exchange funds.

Exceptions for small businesses.  The final regulations provide several exceptions intended to alleviate the burden of loan characterization on small businesses.  The final regulations create an exemption from the I.R.C. §7872 AFR for an exchange facilitator loan that is less than $2 million and lasts six months or less.  On that point, there appears to be no proscription against splitting up an exchange transaction that is over the $2 million limit into multiple pieces, with each transaction begin beneath the $2 million threshold. 

Note:  In reality, though, it may be too costly for taxpayers to break multi-million dollar transactions into smaller parts just to fit under the cap. In addition, the regulations allow taxpayers to use the lower of the short-term AFR or the 13-week T-bill-based rate, when trying to determine a sufficient rate of interest. 
In addition, the final regulations provide a transition period to allow exchange facilitators time to make required changes to accounting, control and reporting systems, and to revise exchange agreements.

Effective Date

So, what’s the effective date of the final regulations?  The final regulations are effective to transfers of relinquished property made on or after October 8, 2008, as well as to exchange facilitator loans on the same basis.  IRS also said that it would not challenge “a reasonable, consistently applied method of taxation for earnings attributable to exchange funds” for property transfers made after August 16, 1986, but before October 8, 2008.


The bottom line on the final regulations is that they provide clarity on a number of issues, but relatively smaller qualified intermediaries may find the facilitation of exchanges more difficult.  T.D. 9413, 73 Fed. Reg. No. 133 (Jul. 10, 2008).