When Section 1031 exchanges go bad...

The IRS recently announced proposed changes to the Qualified Intermediary (QI) program to address what happens when a QI goes under.

Among rental property owners, a Section 1031 exchange offers the major tax benefit of deferring capital gain recognition. For the unfamiliar, this type of exchange permits a property owner to use like-kind exchange rules to sell a property they no longer want. It allows a property owner 45 days to identify a replacement property, and 180 days to close on that property.

Obviously, unless the properties are close by (and in these types of cases, that's often not the case), it's difficult to close both transactions on the same day. And, as anyone who's tried to sell a home can attest, you are more likely to find the replacement property than sell your property - especially in this market.

Originally, the IRS had unclear rules regarding like-kind exchanges of property, but that all changed with sStarker v. United States, 35 AFTR 2d 75-1550, 75-1 U.S.T.C. ¶9443 (1975). In that case, the Starkers agreed to sell their entire interest in timberland to a company, in return for the promise of future land within 5 years. The IRS challenged on a number of grounds, but lost - the court found that the deferral was permitted.

In 1984, Section 1031 was amended to allow such exchanges, subject to time limits, and to hopefully cut down on abuses which arose after Starker (it was further amended in 1986 to change the identification period from 44 to 45 days).

Section 1031 exchanges have thus existed for over 30 years, but it was only recently, as the real estate market took off, that they've entered the common lexicon. In recent years, the problem of far-flung properties has been overcome by the use of qualified intermediaries. These parties facilitate 1031 exchanges by taking title to the sale property or presenting replacement properties (there is such a thing as a 'Reverse 1031,' but that's for another day).

The real problem arises when the QI has taken title to the sale property or cash, and subsequently goes out of business. There have been several recent cases where taxpayers have sought relief in the form of extensions on the 180 day requirement. However, the time deadlines are absolute, and neither the IRS nor the courts have been willing to give on this issue, and Congress has failed to act. Obviously this is a big problem (because the dollar amounts are rarely small; in one recent case, the taxpayer lost over $2 million), and a solution is needed.

This weeks announcement attempts to address that issue, by requiring foreign financial institutions who are QIs to notify taxpayers when internal controls have failed. However, the announcement says nothing about independant QIs, nor US financial institutions, so it remains to be seen if this is just a first step in addressing the issue, or just a tease.