The New Year and 1031 exchanges

If you are in the middle of an exchange, you might be wondering about your exchange that carries over into the new year.

If you are a taxpayer currently conducting a 1031 exchange and your 180 deadline is in 2008, you should NOT file your income tax return prior to completing your exchange. If you proceed with filing your return, you will not be in compliance with section 1031 regulations. Also, if your deadline for completing the exchange is after the April 15th filing date (for personal tax returns) - you will need to file for an extension to complete your exchange.

Otherwise, when you file your return, your replacement period ends - even if your 180-day period is still open. If you have not completed the acquisition, you've invalidated your exchange and guess what? Yep. You now get to pay tax on the sale of that old property.

If you are using a professional Qualified Intermediary, they should be sending you a letter or contacting you by phone to remind you and/or your accountant - just in case you forget this rule. If you are using someone that doesn't, tie a string around that finger, write a note on your refrigerator and call your accountant and make sure they know not to file that return before you've completed your exchange. Oh, and get a QI that does.

"May all your troubles last as long as your New Year's resolutions"
Joey Adams

Possible relief for clients of bankrupt 1031 exchange companies

The IRS recently indicated that it is contemplating tax relief, in some form, for taxpayers have who have not able to complete their like-kind exchange because they used a qualified intermediary (QI) that went bankrupt. In many cases, clients of these bankrupt 1031 exchange companies have not only lost the principal held by the accommodator, they are now subject to capital gains tax and depreciation recapture because they failed to complete their exchange.

In a letter to Representative Barney Frank, a client of a bankrupt 1031 exchange provider requested that the issue of an extension of the period to complete a 1031 like-kind exchange be exteneded. The IRS responded to Rep. Frank that Code Sec. 1031 does not provide for an extension of the statutory replacement period. They also noted that the law only authorizes it to postpone deadlines for Presidentially-declared disasters or terrorist or military actions. However, the Qualified Intermediary that declared bankruptcy action is not subject to one of the events covered under a disaster. Thus, the IRS indicated it does not have the authority to suspend or extend a statutorily mandated due date.

The IRS also said that because of the number of QI businesses that have experienced financial difficulties resulting in bankruptcy filings, the are considering action to provide some type of relief. The nature of that relief was not specified.

The IRS has expressed a willingness to help homeowners that have been subject to foreclosure. While some form of relief for taxpayers for clients of bankrupt QIs is possible from the IRS, there is also the possibility that Representative Frank or other legislators may work to provide statutory relief. Unfortunately, this doesn't get the principal back. That is up to the bankruptcy proceedings - a slow and often times frustrating and disappointing process for these "creditors".

The issue of selecting a competent and secure Qualified Intermediary is highlighted by these recent failures of exchange providers. We focused on What to Look for in a Qualified Intermediary, a couple weeks back. I would encourage you to please review that article along with other references on our linked websites to the right for further guidance.

AMT patch without revenue offsets

Last week the House approved the Senate-passed version of the "Tax Increase Prevention Act of 2007". President Bush is expected to sign the Act. It provides for a one-year patch of the AMT for 2007 but does not offset the revenue cost of the measure with revenue raising provisions.

Under the Act, the AMT exemption amounts for 2007 for individuals will increase from $66,250 for married individuals filing jointly and surviving spouses, up from $62,550 for 2006, $44,350 for unmarried individuals, up from $42,500 for 2006; and $33,125 for married individuals filing separately,up from $31,275 for 2006. It also allows the sum of personal nonrefundable credits (dependent care credit, elderly and permanently disabled credit, mortgage credit, etc) may offset both regular tax and AMT.

Keep in mind, this is only a temporary fix. Congress will still need to address the AMT exemption and the allowance to offset AMT taxes with credits during the 2008 session or the exemptions figures will revert back to the levels set in 2000 ($45,000, $33,750 and $22,500, respectively) and the offsets will go away.

So will they? It probably depends on your political viewpoint and whether they will fix what is sure to a problem for a growing number of taxpayers. One thing can be said, 2007 will result in less tax revenue as a result of the changes and some that were scheduled to creep into AMT will now stay out of this progressive tax. Unique to the passage of this Act is that it didn't involve increasing revenue or offsetting the lower tax with higher taxes in another area. It is widely runoreed that a more permanent fix to the AMT system would have to involve a higher capital gain tax rate - roughly back a 20% long-term rate.

What to Look For in a Qualified Intermediary

Recent news about 1031 exchange accommodators filing bankruptcy or committing fraud with client funds has highlighted the need to carefully select a Qualified Intermediary. Today we'll focus on what items a taxpayer should look at when selecting a QI.

Most important in selecting a Qualified Intermediary is security of funds. When interviewing or researching exchange providers, one should look first and foremost to the financial backing of the company. Not all Qualified Intermediaries have the financial capacity should a problem occcur with the funds they hold. Many are small shops owned by an individual, CPA or law firm. These individual owner providers rely on the honesty and ethics of one or a few individuals. In addition, these individuals may not have the financial capacity to recover should some issue surface within the operation.

Seeking a 1031 exchange provider that is backed by a bank, title company or publically-traded company provides a level of security. If the QI has financial problems, the parent company is there to absorb any losses. In most cases, the exchange business is a relatively small piece of these larger entities and losses can be easily addressed with the financial capacity of the parent. In addition, working with a bank or title subsidiary adds a level of confidence that the QI has greater security measures (checks and balances and separation of duties) within its operation. These controls minimize the ability of one employee to commit fraud. In addition, most bank or title-owned QIs have conservative investment policies that prohibit the QI from speculating on the principal or investing in riskier investments.

One should also ask to the level of fidelity bonding (essentially insurance) that the QI maintains. Most larger QIs will have substantial policies of $10, $25 or $50 million to protect client money. Still, a potential client should not go too far in relying solely on the fidelity bonding. First, it is a policy of the company that protects the client only if the company makes a claim against the bond. In other words, the owner, not the client will be the one to make the claim against the bond. Second, most bonding is on a 'per occurance' basis. Most fidelity bonding is often misinterpreted as a 'per transaction' bonding. So, if the company you have chosen has a $1 million bond but is holding $5 million, there is essentially a 20 cents on the dollar bonding coverage.

Another important security measure is the investment of the exchange funds held in trust. This is important in that, while you have an exchange agreement with a QI, the funds are technically their funds during the exchange period. If the owner of the Qualified Intermediary decides to invest in a high risk hedge fund or wildcat oil project losing the principal, your claim is protected by the exchange agreement alone. It is important to know where your exchange funds are invested. How safe is your principal and how accessible is information about the investment of those funds?

As an additional measure, some QIs place each client's funds in a segregated account. Others pool the funds in an investment account. If problems occur with the funds, pooling is protected only by the exchange company's internal subaccount journal entries. Segregated accounts provide a clearer picture that the funds held in that account are for the benefit of a specific client. While the account will be in the name of the exchange intermediary, it can specified by notating or naming the account for that client.

Safety is of utmost importance in selecting an exchange accommodator. While Qualified Intermediaries must also posses the professional knowledge and customer service that you would expect from a financial partner, your first screening should involve safety. After all, all the expert advice and friendliness in the world will not replace your money if the QI fails.

If you would like further information about What to Look for in a Qualified Intermediary, please contact any of the professionals at 1031 Corporation.

Failed 1031 Exchange at the End of a Tax Year

What happens to a 1031 exchange if a taxpayer sells his relinquished property and is unable to locate a suitable like-kind replacement property within the IRS deadlines? Well, obviously the exchange has not been completed and the gain and depreciation recapture is taxable. But what happens if an exchange is started before the end of the year and cashes out or receives cash after the end of the year? When does the tax liability on the gain get reported? In the case of a failed or partial tax-deferred, like-kind exchange, a taxpayer may be able to defer some of his tax liability into the following income tax year rather than the income tax year in which the relinquished property closed.

Taxpayers who use the delayed exchange safe harbors and meet the requirements of the regulations are entitled to report any gain recognized on the exchange under the installment sale method of tax accounting (See Reg. §1.1031(k)-1(j)(2)). However, the regulation applies only if the Exchange Property is eligible for like-kind exchange treatment and if the taxpayer had a bona fide intent to enter into a 1031 Exchange.

This means that if a taxpayer enters into a delayed exchange before the end of the year and cashes out or receives cash after the end of the year, the gain on the exchange will be reported like an installment sale subject to the rules of IRC §453. The sale of the Relinquished Property will be reported in the year of sale like an installment sale. Cash received after the end of the year from the Qualified Intermediary is taxed in the following tax year. We should note that the tax due from depreciation recapture is not deferred into the following income tax year and is due in the taxable year in which the taxpayer sold the relinquished property.

Does this seem like a great method of deferring income from one tax year to the next by having a Qualified Intermediary hold the cash temporarily? No - unless there was a bona fide intent to complete a 1031 Exchange and there was an Exchange Agreement with a Qualified Intermediary specifically prohibiting access to the exchange funds until the following tax year under the requirements of Section 1.1031 of the Treasury Department Regulations.

We always recommend investors have a team of trusted professional advisors - an attorney, an accountant, a broker, an escrow officer and a Qualified Intermediary. This team will be of even greater importance in a failed exchange occuring over two tax years. A taxpayer should review his or her exchange agreement and consult with his team of professional advisors to determine when the right to obtain access to, or receive the benefits from, the 1031 exchange funds occured. This will help to determine when the income tax liability is due and whether a portion of the tax can be deferred into the following income tax reporting year.

Role of the Qualified Intermediary

The role of the Qualified Intermediary is essential to completing a successful and valid delayed exchange. The Qualified Intermediary is the glue that puts the buyer and seller of property together into the form of a 1031 Exchange. Where such an intermediary (often called an exchange facilitator) is used, the intermediary will not be considered the agent of the taxpayer for constructive receipt purposes notwithstanding the fact that he may be an agent under state law and the taxpayer may gain immediate possession of the money or property under the laws of agency.

In order to take advantage of the qualified intermediary "safe harbor" there must be a written agreement between the taxpayer and intermediary expressly limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the money or property held by the intermediary.

A qualified intermediary is formally defined as a person who is not the taxpayer or a disqualified person who enters into a written agreement (the "exchange agreement") with the taxpayer and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. The qualified intermediary does not actually have to receive and transfer title as long as the legal fiction is maintained.

The intermediary can act with respect to the property as the agent of any party to the transaction and further, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. This provision allows a taxpayer to enter into an agreement for the transfer of the relinquished property (i.e., a contract of sale on the property) and thereafter to assign his rights in that agreement to the intermediary. Providing all parties to the agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as having entered into the agreement and, upon completion of the transfer, as having acquired and transferred the relinquished property.

There are no licensing requirements for Intermediaries. They need merely be not an unqualified person as defined by the Internal Revenue Code in order to be qualified. The Code prohibits certain "agents" of the taxpayer from being qualified. Accountants, attorneys and realtors who have served taxpayers in their professional capacities within the prior two years are disqualified from serving as a Qualified Intermediary for a taxpayer in an exchange.