Originally published on PAOO.
It’s getting a little stale, so I think I should post now on Rev Proc 2010-14 (issued March 5, 2010) or forever hold this piece. Although it is a taxpayer-favorable ruling, its recipients are probably not dancing in the streets. They are probably even more miserable than the beneficiaries of PMTA 2010-05 whom I discussed back in June.
We are talking here about like-kind exchanges. I’ll give you just a bit of context. A common misconception is that you only have taxable income when you get money. In reality, the most general rule is that when you exchange one thing for anything else you should recognize gain or loss by comparing the fair market value of what you received to the basis (generally what you paid) of the thing you gave up. There are of course many exceptions. One of the better known is the like-kind exchange. It is well known enough that its section number 1031 has like 401(k) and 501(c)(3) become part of the language. (You will find Wikipedia entries on each of those three. Don’t go looking for 704(b) in Wikipedia). In order for an exchange to be deferred under 1031 both the relinquished and acquired property must be held for investment or used in a trade and they must be of like-kind. Also, there are several types of property that cannot be the subject of a like-kind exchange (e.g. securities, stock in trade and choses in action (whatever they are)). Whether property is of like kind can be a huge complicated question. There is, however, a huge simplification. All real estate in the United States is like-kind to all other real estate. So although you might have rental car companies exchanging their fleet vehicles and the like, much of the action and excitement in the 1031 area concerns real estate.
Out there in the real world, you don’t have many instances of the two farmers exchanging pasture land that are contemplated in the old 1031 regulations, The chance that someone who wants to buy your property would have a property for sale that you want is pretty slim. People began using middlemen to facilitate exchanges. There was a lot of creativity in the area. Beginning in 1984, which I guess is getting to be a while ago, the Code was amended to place limits on deferred exchanges. Cutting through a lot of complexity you can have a third party receive the money from the sale of your property. You have 45 days to identify a replacement property and they have to get it to you within 180 days (or by the due date of your return including extensions. (You can always get 180 days, but if the sale is later in the year you have to extend your return)).
There are rules about who can hold the money for you. A simple summary of the rules is that if it is somebody who pops into your head, they probably can’t do it. Can’t be the realtor, can’t be your lawyer or your accountant, etc. It doesn’t matter. Exchange facilitation is an industry. You want to use a company that has done many exchanges. Now we are finally getting to Rev Proc 2010-14. What happens if some time during the 180 days your facilitator goes bankrupt?
People used to worry that you would be really screwed if that happened. Since your exchange wasn’t any good you would recognize gain from the sale of the property. Of course, you wouldn’t have any money from the sale to pay the tax, which is why you are really screwed. The IRS isn’t quite as malevolent as some people make them out to be, though. Rev. Proc. 2010-14 says, in part :
The Internal Revenue Service and the Treasury Department are aware of situations in which taxpayers initiated like-kind exchanges by transferring relinquished property to a QI and were unable to complete these exchanges within the exchange period solely due to the failure of the QI to acquire and transfer replacement property to the taxpayer (a “QI default”). In many of these cases, the QI enters bankruptcy or receivership, thus preventing the taxpayer from obtaining immediate access to the proceeds of the sale of the relinquished property. The Service and the Treasury Department generally are of the view that a taxpayer who in good faith sought to complete the exchange using the QI, but who failed to do so because the QI defaulted on the exchange agreement and became subject to a bankruptcy or receivership proceeding, should not be required to recognize gain from the failed exchange until the taxable year in which the taxpayer receives a payment attributable to the relinquished property.
Whoopee. So now you are just screwed as opposed to really screwed.
There is really no excuse for people having gotten themselves in this situation. It is true that some facilitators have a sort of black box business model in which the money disappears when you sell the relinquished property. In that model, it’s none of your concern where the money is in the meantime as long as they deliver the target property. That is not the only model though. It is also permissible for the funds to be segregated in separate bank accounts and some facilitators are affiliated with major banks. Your transaction costs might be a little higher, but it is definitely the way to go.