Under Internal Revenue Code (IRC) section 1031, direct swaps can be difficult to accomplish because the parties may not each have something the other wants. To facilitate exchanges, IRC section 1031 allows taxpayers the use of a qualified intermediary (QI) to avoid the difficulties of locating direct swaps. This article discusses the rules under section 1031 surrounding the QI, as well as the role of the QI, federal and state oversight of the QI industry, and guidance for CPA advisors in the selection of a QI.
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Internal Revenue Code (IRC) section 1031 exchanges remain a popular vehicle to defer capital gains tax for taxpayers who dispose of investment or business property. From the most recent IRS published data, almost 250,000 exchanges are filed annually, with a total value approaching $74 billion (“Data for Like-Kind Property Exchanges, 1995–2013,” http://bit.ly/2apriPD). Moreover, an entire industry has arisen from this provision.
IRC section 1031 direct swaps, exchanges of properties not involving a third party, are difficult to accomplish. To facilitate exchanges, section 1031 allows taxpayers the use of an independent third party to avoid the difficulties associated with direct swaps. This qualified intermediary (QI) is allowed to sell the taxpayer’s property, collect the funds from that sale, and then use those funds to acquire a replacement property for the taxpayer. The rules governing IRC section 1031 like-kind exchanges are complex and carry inherent risks. The use of a QI can be expensive and adds risk to the success of the exchange; the QI will be entrusted with a great deal of money for what can be an extended period of time. It is therefore vital that advisors are able to assist their clients in choosing and maintaining a successful relationship with a QI, including how to properly structure a section 1031 like-kind exchange and utilize QI services.
The tax advisor assumes a vital role in section 1031 exchanges. Not only does she remain the primary source of advice regarding the mechanics of the exchange, but she can also provide valuable guidance in selecting of a reputable QI. This article discusses the rules under IRC section 1031 surrounding the QI. Specifically, it details the role of the QI, federal and state oversight of the QI industry, and guidance in the selection of the QI. It also includes a discussion of recent IRS letter rulings regarding who is and is not a disqualified person.
IRC section 1031(a) states that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” Exchanges of inventory, stocks, bonds, and partnership/multimember LLC interests are excluded. The property that the taxpayer transfers is referred to as “relinquished property,” and the property received as “replacement property.” If any non–like-kind property (boot) is received along with like-kind property, the recipient will recognize gain up to the value of the boot.
As stated above, a direct swap between two parties is infrequent. Even if the first party is willing to exchange his property for the property of the second party, the second party may be unlikely to participate in the exchange for a variety of reasons.
To facilitate exchanges, the IRS has provided safe harbor rules in Treasury Regulations section 1.1031(k)-1(g) that allow exchangors to avoid direct swaps but remain in compliance with the like-kind clause. These safe harbor rules allow an exchangor to sell the property for cash and use the cash to acquire replacement property. The exchangor cannot, however, have access to the cash during the period between the sale of the relinquished property and the acquisition of the replacement property; otherwise, the exchangor will violate the like-kind clause.
Treasury Regulations section 1.1031(k)-1(g) further provides that if an exchangor does not have an immediate ability or an unrestricted right to receive cash during an exchange, then the IRS will determine that the exchangor was not in actual or constructive receipt of cash for purposes of the exchange and therefore did not violate the like-kind clause. To qualify for the safe harbor provisions of Treasury Regulations section 1.1031(k)-1(g)(4), most deferred or delayed exchanges use a QI.
Under Treasury Regulations section 1.1031(k)-1(g)(4), a QI is any person who is not the exchangor or a disqualified person. The same regulations define a disqualified person as any person who has acted as the exchangor’s agent within a two-year period ending on the date of the transfer of the relinquished property. This agent can include, but is not limited to, the exchangor’s employee, attorney, accountant, investment banker or broker, or real estate broker or agent. The performance of services regarding exchanges of property that are intended to qualify for nonrecognition of gain or loss under section 1031, as well as routine financial, title insurance, escrow, or trust services provided to the taxpayer by a financial institution, title insurance company, or escrow company, is not taken into account in the determination of a disqualified person. In addition, a disqualified person includes a related party as described under IRC sections 267(b) or 707(b). Clearly, the intent is to establish an independent relationship between the exchangor and the QI.
The role of the QI is to step into the exchangor’s position and to prevent the exchangor’s access to funds transferred during the exchange process so as not to violate the like-kind clause. For example, consider a Taxpayer X who wants to exchange a three-bedroom residential rental property. A newly married couple may be willing to purchase the house for their own principal residence, but has no property to exchange. Therefore, X transfers the rights to sell the three-bedroom house under a written agreement. The property is then listed with a real estate broker; when the house is sold, the QI transfers the sale proceeds to an escrow account to which X has no access. Under Treasury Regulations section 1.1031(k)-1(c), X has 45 days to identify a replacement property, beginning on the date that the relinquished property was transferred to the buyer. If a replacement property is not received within the 45-day period, X must notify the QI in writing. Once the replacement property is identified and the QI is notified, the QI purchases the replacement property using the funds held in escrow. Under section 1031(a)(3), X has until the earlier of 1) the 180th day after the relinquished property is transferred or 2) the due date of X’s tax return (including extensions) to complete the exchange.
In a deferred exchange, there must be a written exchange agreement under which the QI facilitates the sale of the relinquished property and the acquisition of the replacement property. The QI receives the funds from the sale of the relinquished property, and the exchange agreement expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain benefits of the money or property held by the QI before the end of the exchange period [Treasury Regulations section 1.1031(k)-1(g)(4)].
In a reverse exchange, replacement property is purchased before the sale of relinquished property. Revenue Procedure 2000-37, as modified by Revenue Procedure 2004-51 (2004-2 C.B. 294), provides a safe harbor such that the IRS treats an exchange accommodation titleholder (EAT) as the beneficial owner of property for federal income tax purposes if the property is held in a qualified exchange accommodation arrangement (QEAA). Taxpayers can park either relinquished or replacement exchange properties with an EAT for up to 180 days until the taxpayer is ready to complete the exchange. At the time of sale, the EAT either deeds the relinquished property to the buyer (a “reverse last” method) or holds it until a buyer is found (a “reverse first” method). At the conclusion of the reverse exchange, the EAT transfers title of the replacement property to the exchangor.
The safe harbor provisions permit the taxpayer to enter into a variety of non–arm’s-length transactions, including that the EAT can serve as the QI in a simultaneous or deferred exchange. In addition, the same person can serve as the EAT for the replacement property and as the QI with respect to the sale of the relinquished property. This allows exchange accommodators who have been serving as QIs to provide complete exchange services. Neither the exchanging taxpayer nor a disqualified person can act as an EAT under a QEAA. Reverse exchanges can be extremely complex and therefore carry more risk than forward exchanges. For these reasons, a reverse exchange generally incurs much higher fees. At the same time, reverse exchanges may be more convenient for the taxpayer with regard to locating a replacement property.
Recent IRS private letter rulings have helped define how a QI can perform certain exchange-related activities without being considered a disqualified person. These rulings demonstrate ways in which a QI can perform services that assist like-kind exchanges, thereby saving the taxpayer the additional cost, time, complexity, and risk of hiring unrelated third parties to perform such services.
Private Letter Ruling 201308020 deals with the QI status of a partnership that provides software to like-kind exchange program (LKE) clients. The software allows LKE clients to match relinquished and replacement properties, prepare and submit 45-day identifications, and compute depreciation and gain or loss on LKE assets. The question before the IRS was whether the provision of such software creates an accountant/client or other agency relationship that would deem the partnership a disqualified person. The partnership is not related to any of its clients under IRC sections 267(b) or 707(b), the software was developed in-house, and the software is not commercially available. The partnership does not provide any service to or collect any fees from clients other than those related to like-kind property exchanges.
In the letter ruling, the provision of in-house software to LKE clients did not create an agency relationship that would deem the partnership a disqualified person. Rather, the software was seen as assisting the partnership in performing its duties as a QI and allowed clients to manage high volumes of exchange transactions. The depreciation and gain or loss calculations were deemed automatic mathematical calculations based on data input by clients. Because the ruling states that this does not “rise to the level of an accountant/client or other agency relationship,” the partnership was therefore not a disqualified person.
Letter Ruling 201332010 deals with the status of an EAT that performs services for a taxpayer related to state sales tax trade-ins, specifically regarding the taxpayer’s exchanges of vehicles intended to qualify for nonrecognition of gain or loss under section 1031. The services performed by the EAT are not expressly described in section 4.03 of Revenue Procedure 2000-37 as services “for the taxpayer with respect to exchanges of property intended to qualify for non-recognition of gain or loss under section 1031.” The taxpayer, a State A corporation, was in the business of leasing vehicles. As leases terminate, the taxpayer used the EAT and a QI to exchange used vehicles for new ones. In the capacity of procurement company reseller, the EAT 1) acquired a dealer license for state sales tax purposes and a wholesale dealer license of motor vehicles, 2) acquired vehicle titles for both the relinquished and the replacement properties, 3) registered to do business as a foreign corporation in all states where the taxpayer had transactions, 4) obtained licenses and registrations in different states, and 5) obtained and maintained sales tax permits. The EAT acted as a mere conduit of title between the taxpayer and its wholly owned disregarded entity, and the taxpayer represented that its exchange procedures complied, in all other respects, with the requirements of section 1031(a) of the IRC.
The IRS concluded that the performance of such services did not result in the EAT being a disqualified person, even though such services are not expressly described in section 4.03 of Revenue Procedure 2000-37. The agency considers the services performed by the EAT “akin” to those described in Revenue Procedure 2000-37, and therefore services “for the taxpayer with respect to exchanges of property intended to qualify for nonrecognition of gain or loss under section 1031.”
The private letter rulings above show that intermediaries may perform a variety of services and functions without disqualifying their status as QIs or EATs, as long as they can be reasonably related to facilitating exchange transactions under IRC section 1031. Otherwise, a taxpayer would have to hire unrelated parties to provide these exchange-related services, which could be overly costly and time-consuming.
Regulation of the QI Industry
The QI industry is not currently regulated by the federal government. In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection (Dodd-Frank) Act was signed into law. Under Title X, section 1079 of the Dodd-Frank Act, a newly created independent federal agency known as the Consumer Financial Protection Bureau (CFPB) was charged with reviewing the QI industry. Section 1079 required the CFPB to issue, within one year, a report to Congress recommending regulations of the QI industry. In addition, the agency was to establish, within two years of the issuance of the report, a program to protect consumers who use QIs. On July 21, 2012, the CFPB issued this report, entitled “Report Pursuant to Section 1079 of the Dodd-Frank Act,” but made no recommendations for federal regulation. The agency’s website does not provide any information regarding a program to protect consumers from the QI industry, except for a general complaint area.
Despite the lack of regulations at the federal level, some states have enacted legislation. California, Colorado, Connecticut, Idaho, Maine, Nevada, Oregon, Virginia, and Washington have all passed legislation to oversee the industry. The Exhibit lays out the particulars of each state’s regulation, which are in most respects similar. New Jersey’s pending Senate Bill No. 57 contains similar regulations. This bill would require QIs to provide a 10-day notice for a change of ownership or control, fidelity bond coverage of $1 million, $250,000 error-and-omission coverage, and separate escrow accounts for client funds. Arizona introduced similar legislation in 2010, but it failed to pass the House. The lack of regulation in the QI industry can lead to malfeasance, and both the exchangor and the exchangor’s tax advisor should exercise due diligence when selecting a QI.
State Regulation of the QI Industry
Role of the Tax Advisor
CPAs still assume the primary tax advisory role to the exchangor/client during the exchange process. Generally speaking, QIs may offer tax advice during the exchange process, and some QI companies engage an independent CPA firm as an advisor and then refer this firm to prospective exchangors. In any case, the tax advisor does not take a secondary role in the exchange process. CPAs should advise clients on the rules of IRC section 1031 as well as provide guidance in the selection of a reputable QI.
QIs can be found in any number of ways. Some CPAs may already work on a regular basis with a reputable QI. A taxpayer can also find a QI using professional referral Internet sites or through the Federation of Exchange Accommodators (FEA) (https://www.1031.org). Regardless of how the prospective QI is found, certain due diligence questions should be asked.
Experience and knowledge.
If the QI is located in a state that requires a license, a “license search” can yield when it was originally issued. Such a search, however, does not provide any information on the breadth of the QI’s experience or knowledge. Furthermore, the QI may be located in a state in which no regulation exists. Many times, the only investigation the tax advisor or exchangor can do is ask the prospective QI about his experience. Nonetheless, there may be one way to verify a QI’s knowledge. The FEA has a certification program known as Certified Exchange Specialists (CES). Holders of this certificate must pass the CES exam and meet continuing education requirements. Verification of this designation can be done through the FEA website.
Fidelity or surety bond coverage.
Exchangors should only hire QIs with fidelity or surety bond coverage. Fidelity bonds cover the exchangor if exchange funds are lost due to theft, fraud, or embezzlement. Surety bonds cover the exchangor when the QI is unable to fulfill the terms of the written agreement (e.g., bankruptcy). Exchangors should inquire as to the amount of coverage the QI maintains. Most states regulating the QI industry require a minimum of $1 million coverage; however, the QI’s coverage should be adequate to the exchange at hand. The more coverage the QI carries, the better.
Errors and omissions coverage.
As with fidelity and surety bond coverage, one should investigate the amount of insurance coverage the QI carries for errors and omissions (professional liability insurance). IRC section 1031 is very complicated, and even experienced professionals can make mistakes. If a client suffers damages due to a negligent act of a QI, she should be able to recover those damages if the QI is unable to pay. Again, the more coverage the QI carries, the better.
Safeguarding escrow accounts.
Exchange funds should be deposited and held in separate and segregated qualified trust accounts (QTA) or qualified escrow accounts (QEA). The manner by which these accounts are administered adds additional protection. Withdrawals from these accounts are strictly monitored, requiring a written request made to the escrow agent from the QI. This request must contain a signed authorization from the exchangor, the account number, the amount requested, and the transfer instructions. The QI initiates the wire request by first submitting a disbursement authorization for the exchangor to review, sign, and return to the QI. Then the QI submits the request to the escrow agent; the escrow agent confirms the wire instructions with the exchangor. One area of concern regarding QIs in the past was their ability to transfer funds between holding accounts, comingle exchange funds, and borrow from exchange funds. The use of QTAs and QEAs may reduce the mishandling of exchange funds, although they may not completely prevent it.
In some cases, the QI and the escrow agent may be the same party. If this is the case, an independent escrow agent should be used. Another measure is to use a QI who is a member of the FEA. The FEA requires all members to abide by the FEA’s Code of Ethics and Conduct. Title V of the code requires that monies and property be held in a manner that provides liquidity and preserves principal. Additionally, exchange funds are not to be knowingly commingled or transferred to any other person or entity affiliated with the QI, except for transfers to 1) a financial institution that is a parent or related to the QI for the purposes of placing a deposit under the exchange contract, or 2) an EAT as required under the exchange contract.
It is also a good idea include specific language in the exchange contract about the proprietorship of exchange funds. The FEA suggests the language “the exchange account is to be used solely by the QI for its obligations under this agreement and shall not be deemed a part of the QI’s general assets or subject to the claims of creditors of the QI.” In the case of bankruptcy, the exchange agreement should make it clear that the exchange proceeds are the property of the client and not the QI.
Notification, Accounting, and Fee Structure
Communication and documentation is very important in the exchange process. Not only does a client need to communicate to the QI the details of the exchange, but the QI must also communicate with the exchangor or the exchangor’s tax advisor. Furthermore, the exchangor may have many questions for the QI during the exchange process. An open channel is key to ensuring the process runs smoothly.
As to fee structures, most QIs generate their revenue from transaction fees and the interest earned on exchange proceeds held in escrow. QIs that are part of a larger financial services organization, such as a bank, may be less willing to negotiate their fees; independent QIs, on the other hand, may be more willing. Excessive bargain hunting may not serve the client well, but higher fees do not necessarily mean higher quality. The objective should be to receive the best service at the lowest cost.
Unfortunately, the IRS will not honor a failed exchange due to a QI who defaults on the written agreement because the QI has entered bankruptcy or receivership proceedings during the exchange process. Under bankruptcy proceedings, the QI will not be able to transfer the funds to acquire replacement property and the exchangor, in all likelihood, will not acquire replacement property within the required 180 days. The IRS expects a strict adherence to the rules of section 1031, and the exchangor cannot defer gain on a failed exchange due to a QI who defaults on the written agreement. The IRS has, however, provided guidance for exchangors who find themselves in this situation. Revenue Procedure 2010-14 (2010-12 IRB 456) provides that no gain shall be recognized on a failed exchange until the taxpayer has received payment or payments from a QI released from bankruptcy proceedings. It also requires the taxpayer use the gross profit margin method to recognize gain when the taxpayer does receive payment from the QI.
The Three-Person Exchange Team
An IRC section 1031 like-kind exchange can be a complex process. It is critical that the exchangor consult his tax advisor throughout the process to ensure compliance with the exchange rules. In addition, both the exchangor and tax advisor must do their due diligence when choosing an experienced and competent QI in order to protect the exchange process and exchange funds. Advisors and intermediaries should especially be aware of recent private letter rulings that demonstrate ways a QI can perform services that aid an exchange without becoming a disqualified person. The exchangor and tax advisor should interview QIs just as they would any prospective employee or team member. Ultimately, all three must work together to ensure the team’s objective: a successful exchange.