The IRS recently issued Revenue Procedure 2010-14, which provides long-awaited guidance for taxpayers whose deferred like-kind exchange of relinquished property would be non-taxable under Section 1031 of the Internal Revenue Code but for the failure of the qualified intermediary ("QI") to acquire and transfer identified replacement property due to the QI's insolvency proceedings.

This update provides general background information on Section 1031 and summarizes the key highlights from Revenue Procedure 2010-14.

General Background on Section 1031

Section 1031 and the regulations thereunder provide criteria for a nontaxable exchange of property.  No gain or loss is recognized on the sale of property that is held for productive use in a trade or business or for investment if the property is replaced with a property of like kind for similar use.  To qualify for nonrecognition, the taxpayer must:

• Identify the replacement property within 45 days of the transfer of the relinquished property; and
• Acquire the replacement property within 180 days of the transfer of the relinquished property, or by the due date of the taxpayer's return for the transfer year, if sooner.

The taxpayer may employ a QI to accomplish the acquisition and transfer of the relinquished property from the taxpayer and the replacement property to the taxpayer.  If a QI enters bankruptcy or receivership proceedings, taxpayers may be prevented from obtaining immediate access to the funds from the sale of any relinquished properties and be unable to acquire replacement property within the required time period under Section 1031.  Prior to the issuance of Revenue Procedure 2010-14, this arguably caused such taxpayers to lose the protection of Section 1031 and be subject to taxation based on the taxpayer's agent having receipt of the consideration for the relinquished property.

Highlights of Revenue Procedure 2010-14

If a taxpayer's effort to complete a proper deferred like-kind exchange under Section 1031 is frustrated solely because the QI holding the taxpayer's proceeds from the sale of relinquished property enters bankruptcy or receivership proceedings, the IRS will treat the taxpayer as not having actual or constructive receipt of the proceeds during that period prior to payment if the taxpayer reports gain in accordance with the safe harbor gross profit ratio method.  The taxpayer need only recognize gain as he receives payments attributable to the relinquished property.  However, if the payments received exceed the tax basis of the relinquished property, no tax loss can be taken even if the payments received are less than the value of the relinquished property.

The safe harbor gross profit ratio method is determined by multiplying the payment attributable to the relinquished property by a fraction, where the numerator is the taxpayer's gross profit and the denominator is the taxpayer's contract price.  For applying the safe harbor gross profit ratio method, the following definitions apply:

• A payment attributable to the relinquished property is a payment of proceeds, damages, or other amounts attributable to the disposition of the property (except selling expenses), whether paid by the QI, the bankruptcy or receivership estate of the QI, the QI's insurer or bonding company, or any other person.  Satisfied indebtedness is not a payment attributable to the relinquished property unless it exceeds the adjusted basis of the property.
• Gross profit is the selling price of the relinquished property minus the taxpayer's adjusted basis in it (increased by any selling expenses not paid by the QI using proceeds from the sale of the relinquished property).
• The selling price of the relinquished property is generally the amount realized on its sale, without reduction for selling expenses.  But if a court order, confirmed bankruptcy plan, or written notice from the trustee or receiver specifies, by the end of the first taxable year in which the taxpayer receives a payment attributable to the relinquished property, an amount to be received by the taxpayer in full satisfaction of the taxpayer's claim, the selling price of the relinquished property is the sum of the payments attributable to the relinquished property (including satisfied indebtedness in excess of basis) received or to be received and the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.
• The contract price is the selling price of the relinquished property minus the amount of any satisfied indebtedness not in excess of the adjusted basis of the relinquished property.

The maximum gain to be recognized under Revenue Procedure 2010-14 is the sum of:

• The payments attributable to the relinquished property (including satisfied indebtedness in excess of basis); and
• The satisfied indebtedness not in excess of basis, minus the adjusted basis of the relinquished property.

A Section 165 loss deduction may be claimed for the amount, if any, by which the adjusted basis of the relinquished property exceeds the sum of:

• The payments attributable to the relinquished property (including satisfied indebtedness in excess of basis), plus
• The amount of any satisfied indebtedness not in excess of basis. 

Taxpayers entitled to this deduction may also claim a loss deduction under Section 165 for the amount of any gain recognized in accordance with the revenue procedure in a prior taxable year.  However, as stated above, if the payments exceed the amount of tax basis, no tax loss is allowed with respect to the economic loss arising from the payments being less than the value of the relinquished property.

Additional Information

This update is only intended to provide a general summary of the new IRS guidance with respect to failed like-kind exchanges as detailed in Revenue Procedure 2010-14. You can read the full text of the Revenue Procedure here.