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Closed Sales: Conversion to Exchange?
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
A broken exchange may arise when a taxpayer attempts an exchange on his
own and discovers that Section 1031 does not allow the tax-free reinvestment
of the proceeds that the taxpayer has received in a closed sale. The only
legal option in this situation is rescission (or perhaps reformation)
of the original transaction. A failed exchange may also arise in an attempted
deferred exchange after the relinquished property is transferred when
the taxpayer fails to identify or receive replacement property as required
by Section 1031(a)(3). Problems may also arise if the taxpayer receives
only one of several identified replacement properties and desires to receive
the remaining exchange balance before the end of the 180-day exchange
period. All may not be lost to the taxpayer in such situations and techniques
may be available to ease the taxpayer’s pain. These techniques include:
(1) rescinding the original transaction (in an attempt to avoid a taxable
sale) or, alternatively, reforming the transaction to reflect a manifested
intent to exchange; (2) a one-year deferral under the installment sale
rules; or (3) the issuance of the intermediary’s note to the taxpayer
(in an attempt to qualify for installment sale reporting of the gain).
Rescission or Reformation. If the transaction has closed as a sale, it
is very questionable whether the entire transaction may be rescinded and
subsequently recreated as an exchange. To be effective for tax purposes,
rescission generally requires, among other things, the reconveyance of the
relinquished property by the purchaser to the taxpayer in the same tax year
as the original transfer. If the transaction can be effectively rescinded,
then a taxable sale may be avoided. Rescission is the retroactive voiding
of a contract that has the effect of releasing the contracting parties from
further obligations to each other under the original contract and restoring
the parties to the positions that they occupied before the original contract
was consummated. Rescission is distinguishable from a sale and repurchase.
When property is sold, gain or loss is realized and recognized in the year
of sale, notwithstanding any agreement made in a later year to take back
the property. However, a rescission that occurs in the same year as the
original transaction generally extinguishes the original transaction and
the resulting tax attributes. The rescission technique is discussed extensively
in Platner, “Rescission: Path to Repair a Broken 1031 Exchange,” Real
Est. Tax Digest (December 1999) at 393; Banoff, “Unwinding or Rescinding
a Transaction: Good Tax Planning or Tax Fraud,” Taxes (December 1984).
Many practical limitations preclude an effective rescission of a closed
sale. At a minimum, a cooperative buyer is required who is willing to reverse
the original transaction. Lenders and other third parties may also prevent
rescission by imposing loan prepayment penalties or other exorbitant costs.
There may not be time to unwind a sale that is consummated late in the tax
year during the same tax year. For these and other reasons, actual rescission
will often not be feasible. The question remains whether the sale could
be “reformed” if the parties intended to make an exchange but
failed to do so through fraud, mistake or other sufficient cause under applicable
contract law. There is no authority that specifically addresses a mutually
agreed reformation of a closed sale so as to convert it to an exchange.
The IRS is likely to insist that that once the taxpayer had actual or constructive
receipt of the sales proceeds, the transaction was taxable irrespective
of any subsequent reformation of the transaction. The taxpayer, on the other
hand, could argue that the proceeds were initially received in a constructive
trust as a result of fraud, mistake or other good cause and were promptly
transferred in accordance with the agreed reformation of the transaction.
One-Year Deferral. All is not lost in a failed exchange that begins in
the second half of the tax year and ends in the next tax year upon the expiration
of the 180-day period. A deferred exchange is said to straddle tax years
when the transaction terminates in the next tax year and the taxpayer then
actually or constructively receives cash. The regulations address the interaction
of Sections 1031 and 453 with respect to deferred exchanges that straddle
tax years. The rules of Reg. Section 1.1031(k)-1(j)(2) address the use of
a deferred exchange to create a one-year deferral under the installment
sale rules, including where the deferred payment obligation is secured by
cash or cash equivalents in the form of a safe harbor security, escrow,
trust or intermediary arrangement. The applicable rule is that income is
recognized in the year that cash is actually or constructively received
under Reg. Section 1.1031(k)-1(g)(1). In light of the liberal safe harbors
protecting taxpayers from constructive receipt, the Service had a concern
that taxpayers would use the deferred exchange rules to evade limitations
on the rules for cash-equivalent security for installment obligations set
out in Reg. Section 15A.453-1(b)(3)(i). The Service’s solution to
its concern was to impose a “bona fide intent” requirement on
exchanges that straddle tax years and involve the receipt of boot in the
next tax year.
As long as the taxpayer meets the bona fide intent requirement, the taxpayer
will receive a one-year deferral for a deferred exchange that fails in the
next tax year. The failed exchange will qualify for installment reporting
under Section 453, despite the fact that the taxpayer’s use of the
exchange safe harbors would otherwise preclude installment sale reporting.
In the absence of an anti-abuse rule, taxpayers could achieve a one-year
rollover of gain simply by commencing a deferred exchange. To qualify for
deferral, at time of the creation of a safe harbor arrangement, the taxpayer
must have a bona fide intent to complete an exchange: “A taxpayer
will be treated as having a bona fide intent only if it is reasonable to
believe, based on all the facts and circumstances as of the beginning of
the exchange period, that like-kind property will be acquired before the
end of the exchange period.” Reg. Section 1.1031(k)-1(j)(2)(iv) (emphasis
added). See also Smalley v. Commissioner, 116 T.C. 450 (2001) (interpreting
the bona fide intent requirement).
Taxpayers have the burden of showing qualifying intent, but based on the
examples contained in the regulations this may not be hard to do. The examples
in Reg. Section 1.1031(k)-1(j)(2)(vi) do little to address the subtleties
of determining bona fide intent. Examples 1 and 2 assume correct intent
and merely illustrate consequences of use of qualified escrow and qualified
intermediary structures where replacement properties are identified and
both property and cash are distributed at the conclusion of the exchange.
The result is recognition of income in the year that the cash is received.
Example 3 assumes correct intent and provides that if the taxpayer does
not identify property and receive funds after 45 days, recognition is in
the year that the cash is received. Example 4 deals with the use of a qualified
intermediary as a conduit for a note received from the buyer of relinquished
property. On distribution of the note following the receipt of replacement
property, the taxpayer may report payments using the installment method.
Examples 5 and 6 address the intent issue under very narrow facts. Example
5 involves a corporate exchanger which has held property X for expansion,
decides to sell it and obtain other property for expansion, but shortly
thereafter (in a subsequent tax year) decides not to proceed with expansion.
The result is that no replacement property is identified and the qualified
intermediary distributes the sale proceeds from the sale of property X at
the end of the identification period. There is no indication of any actual
conduct by the corporation that reflects its intent, simply a change of
mind. Commentators have suggested that this invites good minute keeping.
Example 6 describes a highly unusual exchange in which a taxpayer transferred
property to the buyer, and the buyer deposited the agreed value into a qualified
escrow account. The taxpayer specified that it wanted to acquire replacement
property zoned for commercial development, but identified only property
currently zoned residential. The taxpayer was unable to get any of the properties
rezoned commercial (although the example states that the local zoning board
had rezoned similar properties for commercial use in recent years). The
negative zoning decision occurred in the year following the transfer of
the relinquished property, whereupon the funds were released from the escrow
to the taxpayer. The taxpayer here is unlucky. What would have happened
if rezoning was obtained, but the taxpayer changed his mind? We await case
law or rulings to elaborate on other circumstances where bona fide intent
is present.
If one or more replacement properties are received but the balance of cash
is distributed in the next tax year, the taxpayer will have a combined exchange
and installment sale. Reg. Section 1.1031(k)-1(j)(2) will apply to the cash
received in the next tax year and allow for installment sale reporting.
A combined installment sale and exchange will also occur if the buyer’s
or intermediary’s note is distributed to the taxpayer after the completion
of the exchange. Section 453(f)(6) governs the combined installment sale
and like-kind exchange. If the value of the replacement property exceeds
the taxpayer’s basis in the relinquished property, all of the taxpayer’s
basis will become associated with the replacement property and the taxpayer
will not have any tax basis in the installment note. Thus, all of the payments
that the taxpayer will receive on the note will be fully taxable but the
gain will be reported over time under the installment method.
Installment Note of QI. If the buyer’s installment note (the note
of the intermediary’s transferee) is treated as the installment note
of the exchanger’s transferee for purposes of Section 453, can the
intermediary’s note also be considered the note of the exchanger’s
transferee? Reg. Section 1.1031(k)-1(j)(2)(iii) provides that the receipt
by the taxpayer of a note of the transferee of the qualified intermediary
is treated as the receipt of the note of the person acquiring property from
the taxpayer for purposes of Section 453. Section 453(f)(3) provides that
the term “payment’ does not include the receipt of a note of
the person acquiring the property (whether or not the note is guaranteed
by another person), unless the note is payable on demand or is readily tradable.
See also Reg. Section 15A.453-1(b)(3)(i). However, a note from any other
person who does not acquire the taxpayer’s property (i.e., a third-party
note) is treated as a payment. Third-party notes generally include notes
owned by the taxpayer’s transferee and passed through to the taxpayer.
Given the above regulation, it is not certain that the note of an intermediary
can also be treated as the note of the taxpayer’s transferee for purposes
of Section 453. Will it matter if the intermediary is or is not an agent
of the exchanger under general tax and/or legal principles? Does the intermediary’s
status change to an agent following expiration of the safe harbor periods?
None of these questions have definitive answers.
Reg. Section 15A.453- 1(b)(3)(i) refers to special rules regarding the
receipt of a note of a transferee of a qualified intermediary, citing Section
1.1031(b)-2(b) (simultaneous exchange) and 1.1031(k)-1(j)(2)(iii) (deferred
exchange). The question is whether these special rules supplement or supersede
the otherwise applicable treatment of the qualified intermediary as the
taxpayer’s transferee (i.e., its status as the person acquiring the
taxpayer’s property). The special rules simply treat the buyer’s
note as the note of the person acquiring property from the taxpayer for
purposes of Section 453. They do not provide that an intermediary’s
note fails to qualify under the general rule of Section 453(f)(3) and the
above regulation. Further, the special rules still regard the buyer as the
transferee of the qualified intermediary and thus should be construed as
providing special treatment only for such notes and not as superseding the
general rule. If this is not the case, back-to-back notes (i.e., a note
from the buyer to the intermediary and a note from the intermediary to the
taxpayer) will not qualify for installment reporting under Section 453 (unless
the intermediary is treated as the taxpayer’s agent). That result
is inconsistent with case law that has held an intermediary to be an independent
principal and not the taxpayer’s agent.
Thus, the intermediary’s note to the taxpayer should potentially
qualify for installment reporting in the same way as the buyer’s note.
However, the intermediary’s status for periods after the end of the
exchange period will be judged on general principles. The intermediary will
no longer be protected by the safe harbor. For the intermediary’s
note to be respected, the intermediary will need to be independent of the
exchanger and treated as the purchaser of the relinquished property for
Section 453 purposes under the general rule. See Rushing v. Commissioner,
441 F.2d 593 (5th Cir. 1971). The exchange contract itself could provide
for deferred payment of the exchange credit if replacement property is not
transferred prior to the expiration of the exchange period. The cash payout
of exchange credit would be on an installment basis and the taxpayer could
report gain on a failed exchange over five, ten, twenty or more years in
appropriate circumstances. One interesting problem that must be addressed
is how the parties will deal with any interest rate differential between
what is earned on funds representing the exchange credit and what must be
paid on the installment note if Section 1274 rates exceed current bank yields
on deposits. For intermediaries, the possible conversion to installment
sale treatment raises questions concerning their status (agent v. independent
party) and the form of disclosure, if any, that must be made to clients.
If the intermediary’s note is issued to the exchanger, a key issue
will be the security for the note, given the potential for bankruptcy of
an intermediary, other financial instability, fraud or embezzlement. Fortunately,
the installment sale rules permit the note to be guaranteed by any third
party and also to be secured by a standby letter of credit (which is treated
the same as a third party guarantee). See Reg. Section 15A. 453-1(b)(3)(i).
A standby letter of credit is a non-negotiable, non-transferable (except
with the note it secures), letter of credit issued by a bank or other financial
institution. The standby letter of credit serves as a guarantee of the note
secured by the letter of credit. A letter of credit is not a standby letter
of credit if it may be drawn upon in the absence of default in payment of
the underlying note. See Reg. Section 15A. 453-1(b)(3)(iii). Thus, a standby
letter of credit may be used to secure the intermediary’s note.
In contrast, using cash or a cash equivalent in a qualified escrow or trust
account to secure the note would not be allowed under Section 453 (except
during the exchange period as permitted under Reg. Section 1.1031(k)-1(j)(2)(i)).
Unlike a note secured by a standby letter of credit, receipt of a note secured
directly or indirectly by cash or a cash equivalent, such as a bank certificate
of deposit or a treasury note, is treated as the receipt of payment. See
Reg. Section 15A. 453-1(b)(3)(i). Reg. Section 15A. 453 -1(b)(5), Example
(7), indicates that an intermediary could post the exchange funds as collateral
to secure the letter of credit with the issuing bank. Thus, the taxpayer
should be fairly well-secured. Although the taxpayer will not have a direct
lien upon or other security interest in the cash or cash equivalent collateral,
the taxpayer will have a letter of credit to draw upon in the event of any
default in payment by the intermediary, thereby substituting the credit
of the intermediary for the credit of the issuing bank.
The tax benefit of this technique depends on all the facts and circumstances,
including the amount of tax deferral that may be achieved. Section 453A
severely limits the benefit of this technique for large transactions in
excess of $5 million by imposing interest on the deferred tax liability.
Moreover, if there is significant debt relief or Section 453(i) depreciation
recapture on the transfer of the relinquished property, a substantial portion
of the gain may have to be recognized in the year of sale. The debt relief
problem may be avoided by having the buyer assume or take subject to the
mortgage, if possible. The mortgage must be qualifying indebtedness under
Reg. Section 15A. 453-1(b)(2)(iv) (i.e., a debt functionally related to
the acquisition, holding or operating of the property and not incurred in
contemplation of the disposition of the property). Then only the debt in
excess of basis, if any, would be treated as a payment in the year of sale.
See Reg. Section 15A. 453-1(b)(3)(i). A wrap-around mortgage could also
be used in an attempt to avoid debt in excess of basis or for other reasons.
This article has discussed how taxpayers can make the most out of a failed
exchange. What has been suggested may not be tantamount to making lemonade
out of lemons but these techniques may alleviate some of the bitterness
of a failed exchange. In each of these situations, the qualified intermediary
may be confronted with difficult issues. An intermediary’s overall
policies, practices and reputation may be implicated. Intermediaries will
need to see the forest through the trees, and they may not be willing or
able to accommodate each taxpayer’s wishes in these situations.
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