The Perils of a Tax-Deferred Exchange When the Qualified Intermediary Goes Bankrupt
Under I.R.C. §1031, property that is used in the taxpayer’s trade or business or is held for investment can be traded for property of a like-kind with the tax on the transaction deferred until the disposition of the replacement property. Sometimes a trade occurs simultaneously with the buyer and the seller entering into an exchange directly with each other. But, that’s not the usual way a tax-deferred exchange occurs. Often it’s difficult to find two parties that want to exchange property with each other. So, the Code allows for deferred exchanges – the seller’s property is sold with the proceeds of the sale parked with a “qualified intermediary” until a suitable replacement property is found (within certain time limits). The qualified intermediary plays an important role because the seller cannot take possession of the sale proceeds. To do so blows the tax-deferred nature of the exchange. Thus, it’s critical that the qualified intermediary take title to the seller’s property, sell it within the statutorily-prescribed time-frame and then acquire the replacement property (also within a certain time-frame) and transfer the replacement property to the seller.
A recent case, however, points out the potential peril facing transferors when using a qualified intermediary. What happens if the qualified intermediary files bankruptcy after property has been transferred to it, but before the exchange has been completed? Does the seller become a general unsecured creditor of the qualified intermediary – with little hope of recovering its property?
LandAmerica 1031 Exchange Services, Inc. is a qualified intermediary. It filed bankruptcy at a time when 450 of its customers had parked approximately $420 million with the company and were waiting to complete their various exchange transactions. The customers wanted their money back and claimed that LandAmerica held it either in escrow or in trust for them outside of the bankruptcy. But, the bankruptcy trustee claimed that the customers’ documentation with LandAmerica never established trust or escrow accounts and, as a result, the customers were general unsecured creditors to be paid after LandAmerica’s secured creditors get paid (and then only on a pro-rata basis).
The Bankruptcy Court agreed with the trustee – the customers’ funds were not held in trust or escrow. The court noted that the words “trust” and “escrow” never appeared in the written exchange agreements the customers entered into with LandAmerica. That’s a key point. The court focused on the specific language of the exchange agreement as well as the structuring of the bank accounts. The court noted that the exchange agreement transferred to LandAmerica “sole & exclusive possession, dominion, control and use of the Exchange funds” and specified that the exchanging party had “no right, title or interest in or to the exchange funds or any earning thereon.” That’s probably not the typical language that a qualified intermediary would use. The court also noted that LandAmerica commingled exchange funds with their operating funds. That made it easy for the court to conclude that the customers intended LandAmerica to treat the funds as its own and made the relationship between the parties more like a debtor/creditor one rather than one more akin to a trustee/beneficiary. So, the outcome of the case may be tied to the particular facts of the case and may not apply to all bankrupt qualified intermediaries that use less onerous language in exchange agreements – language that more closely follows the safe harbors in the Treasury Regulations. But, based on a strict reading of the bankruptcy code as applied to the facts in the case, the customers were treated as unsecured creditors. In addition, LandAmerica had invested the customers’ funds in auction-rate securities which are very difficult to value and may be substantially impaired given the current credit climate (that’s also an investment strategy that got LandAmerica in trouble – they ended up with worthless debt). Also, the customers will have to fork over attorney fees for their representation in the matter.
The Internal Revenue Code doesn’t stipulate what a qualified intermediary can or can’t do with customers’ funds – they are completely unregulated. But, the court pointed out that the customers could have easily created a trust or escrow account with LandAmerica if they had wanted to. Indeed, as mentioned above, existing Treasury Regulations provide safe harbors for parking funds with or without using a qualified intermediary. That’s the tough lesson of the case – the problem was completely avoidable with proper planning. In addition, the customers could have specified contractually how their funds were to be invested while their deals were pending.
Will the Congress step in to change the rules governing qualified intermediaries? The court’s opinion points out that self-regulation was possible here and existing law provides sufficient planning opportunities to avoid the problems that happened here, but lately the Congress seems bent on taking over numerous sectors of the economy. So what’s to stop them on this one? Will the IRS grant relief? Remember, if the qualified intermediary files bankruptcy and the deal can’t be done within the prescribed timeframes tax is not deferred. IRS has said in recently issued Information Letters that if a taxpayer incurs a loss when a qualified intermediary goes belly-up, the loss is deductible from gross income in the year the loss is sustained. That means the year the transaction is closed, completed and fixed by identifiable events occurring in that tax year. The filing of bankruptcy may not be the identifiable event that closes the transaction, but it certainly is a step down that road. Unfortunately, when funds get tied up in bankruptcy the actual amount of the taxpayer’s loss can remain uncertain for several years. Since no deduction is allowed until the loss is determined with reasonable certainty, the taxpayer may have to pay tax on the gain in the year of the transfer but would not be able to claim any associated deductible loss until several years in the future when it becomes known how much of the funds is actually unrecoverable. Also, in the Information Letters, IRS said it is considering some type of relief for taxpayers caught-up in the bankruptcy of a qualified intermediary.
Note: The case is In re Land America Financial Group, Inc., et al., No. 08-35994-KHR, 2009 Bankr. LEXIS 940 (Bankr. E.D. Va. Apr. 15, 2009) and the IRS Information Letters are Info. 2009-0063 (Mar. 26, 2009) and Info. 2009-0066 (Mar. 26, 2009).
On March 5, 2010, the IRS did grant the relief that it had earlier said it was considering. In Rev. Proc. 2010-14, 2010 I.R.B. LEXIS 103, IRS provided a safe harbor method or reporting gain or loss for taxpayers who fail to complete a like-kind exchange due to a qualified intermediary’s bankruptcy. With the Rev. Proc., IRS says that a taxpayer who relies in good faith on a qualified intermediary to complete a like kind exchange, but can’t complete the exchange because the qualified intermediary ended up in bankruptcy or receivership does not have recognized gain from the exchange until the tax year in which the taxpayer receives a payment attributable to the relinquished property. So, the safe harbor basically utilizes the same rules that apply to money received under an installment sale. Here’s how IRS says a taxpayer qualifies for the safe harbor relief – the taxpayer must have transferred property in accordance with the like-kind exchange regulations; must have timely identified the replacement property; must not have completed the exchange because the qualified intermediary wound up in bankruptcy or receivership; and must not have had actual or constructive receipt of the proceeds from the disposition of the relinquished property before the qualified intermediary filed bankruptcy or went into receivership (but, being relieved of a liability under the exchange agreement before the qualified intermediary failed is ignored). If a taxpayer meets those four tests, the taxpayer doesn’t have any gain or loss to report until the tax year in which payment (from the qualified intermediary, the qualified intermediary’s bankruptcy or receivership estate, or the qualified intermediary’s insurer or bonding company or any other person) is received. In that year, of course, the taxable amount of any funds received is a function of the taxpayer’s basis in the property – and that’s a function of the taxpayer’s gross profit percentage and the contract price. The Rev. Proc. lays out further details concerning the definition of “contract price” and “gross profit” and “satisfied indebtedness.” As for imputed interest, IRS says that the property is deemed to be sold when the bankruptcy plan is confirmed (or upon any other court order resolving the taxpayer’s claims against the qualified intermediary). That means there is no imputed interest if the only payment that fully satisfies the taxpayer’s claim is received within six months after the safe harbor date – which is January 1, 2009. The IRS is taking comments on the safe harbor rule as long as they are submitted by April 12, 2010.
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