Failed 1031 Exchange Gains When QI is Bankrupt or in Receivership

After several 1031 intermediary failures, the IRS has finally granted tax relief for taxpayers who were unable to complete their exchange because their Qualified Intermediary (QI) entered into bankruptcy or receivership.

Revenue Procedure 2010-14 provides guidance on how to report income from the sale of property when a 1031 exchange fails due to a QI bankruptcy. In order to qualify under this procedure, the QI has to be subject to a bankruptcy proceeding under the United States Code or in receivership under federal or state law.

Ordinarily, a sale of property is reported and taxes are paid in the year of sale. If sale proceeds are to be received in installments, the sale can be reported under the “installment sale rules” of Code Section 453. This code section allows the gain to be reported and taxed ratably as contract price payments are received.

In a 1031 Exchange, taxpayers may begin an exchange in one tax year and complete the exchange in a subsequent year. When the exchange "fails", they may not receive their proceeds (known as "boot") until the year subsequent to the relinquished property sale. The tax on the boot received can be deferred to this subsequent year under the installment sale rules (Reg. §1.1031(k)-1(j)(2)).

Revenue Procedure 2010-14 recognizes taxpayers who have entered into an exchange that has failed due to QI bankruptcy or receivership. Taxpayers that have been caught up in a QI bankrutpcy may not posess any of the receiver-disbursed funds until a subsequent year. Taxpayers may receive little or no proceeds from the bankruptcy or receivership until after the proceeding is closed.

Revenue Procedure 2010-14 permits taxpayers to report gain on the sale in a procedure similar to the installment sale rules of IRC §453 and Reg. §1.1031(k)-1(j)(2). Tax on the cash received is deferred until cash is actually received. Taxable gain on the cash received is calculated in a manner similar to the installment sale rules. If the taxpayer received less than the property was sold for, the calculation of the gain is reduced accordingly.

Revenue Procedure 2010-14 is a little more complicated than this explanation. Taxpayers should consult their tax professionals for a complete explanation. With this new recognized procedure for reporting, the IRS has provided clearer guidance to those who have, unfortunately, been caught in a failed 1031 Exchange due to QI bankruptcy or receivership.