IRS Considering Relief for Taxpayers Caught Up With Bankrupt QIs

Large and small 1031 Exchange Qualified Intermediaries (QIs) have gone into bankruptcy in the last couple of years for a variety of reasons, including frozen liquidity in the financial markets and questionable diversion of exchange funds to fund loans to related companies. This has caused taxpayers to not only lose their 1031 exchange funds but to also have income tax liabilities for incomplete replacements under §1031 for the sale of their real estate.

Congressmen and Senators have been receiving complaints from their constituents for some kind of tax relief in these circumstances and the IRS has been receiving appeals to do something about this. As a result, the Internal Revenue Service is notifying Congressmen and Senators that it is working on some kind of relief for taxpayers who have been unable to timely complete a like-kind exchange because the used a Qualified Intermediary that went bankrupt.

Up to now, the position of the IRS has been that a sale of property is taxable if the 1031 Exchange fails due to a bankrupt QI with no taxpayer relief.

The IRS has also said that if a taxpayer sustains a loss of exchange funds due to a bankrupt QI that is not compensated for by insurance or otherwise, he can deduct the loss from gross income under Code Section 165(a), but only in the year the loss was sustained. Sometimes the loss is sustained in the year following the tax year of sale of the relinquished property and is not available for offset of the taxable gain on the sale of the relinquished property.

As a result of all the controversy over bankrupt QIs, the Internal Revenue Service is now saying that it is contemplating some type of relief for affected taxpayers. The IRS has been promising action on this issue since the fall of 2007 when the real estate market started heading south in many areas.

We’ll have to wait and see.