In this Tax court opinion, filed June 19, 2014, the taxpayer challenged the IRS's determination that: (1) the taxpayer's sale of certain property and subsequent purchase of unimproved land did not qualify as a deferred exchange under Internal Revenue Code Section 1031 because the taxpayer failed to use a qualified intermediary, and (2) that the taxpayer's basis in the property may not be increased by the sums of the property settlement payments he paid to two former spouses incident to his respective divorces.
Section 1.1031(k)-1(a) of the Income Tax Regulation (Regs.) governs the treatment of deferred exchanges under Internal Revenue Code Section 1031. "In order to constitute a deferred exchange, the transaction must be an exchange (i.e., a transfer of property for property, as distinguished from a transfer of property for money)." Section 1.1031(k)-1(f)(1) provides: "A transfer of relinquished property in a deferred exchange is not within the provisions of section 1031(a) if, as part of the consideration, the taxpayer receives money or other property." For taxpayers who do not meet this requirement, Section 1.1031(k)-1(g) provides four safe harbors allowing them to sell property while still enjoying the non-recognition benefits of Section 1031.
One of the safe harbors, Section 1.1031(k)-1(g)(4), provides that if a taxpayer uses a "qualified intermediary", the taxpayer's sale of relinquished property and subsequent purchase of like-kind replacement property will be treated by the IRS as an exchange. The taxpayer will not be treated as if in actual or constructive receipt of money or other non-qualified property before the taxpayer actually receives like-kind replacement property. A qualified intermediary must satisfy a number of requirements, including the requirement that he/she not be a "disqualified person".
The taxpayer here stipulated that there was no direct exchange of like-kind property; the relinquished property was sold and the replacement property was purchased with proceeds from the sale of the relinquished property.
The taxpayer employed his son, an attorney, to serve as the intermediary facilitating the taxpayer's attempted Section 1031 exchange. The taxpayer reinvested the exchange proceeds into like-kind replacement property otherwise complying with the Section 1031 safe harbor exchange requirements. The taxpayer took the position that this exchange should have been valid with his son serving as intermediary because; his son was an attorney, the exchange proceeds from the sale of the relinquished property were held in an attorney trust account, and the transaction documents explicitly stated that the transaction was part of a 1031 exchange.
The Court rejected the taxpayer's arguments noting that the Internal Revenue Code Section 1031 requirements are very specific regarding who may not be a qualified intermediary. Neither the taxpayer nor anyone considered a Disqualified Person can serve as a qualified intermediary. The definition of "disqualified person," set forth in Reg. 1.1031(k)-1(k)(3), is very explicit, and a son is specifically disqualified from being an intermediary, regardless of his or her profession. In addition, Sec. 1.1031-1(k)(3), of the Regs provides that persons who bear a relationship described in section 267(b), such immediate family members including ancestors and lineal descendants, are also disqualified persons and it was this provision that the Tax Court relied upon in confirming the IRS's determination that a valid exchange had not occurred.
Taxpayers contemplating engaging in an Internal Revenue Code Section 1031 tax deferred exchange and those advising them must recognize that the classification of those parties who are considered disqualified persons encompasses more than just relatives. Sec. 1.1031-1(k)(2) of the Income Tax Regs specify that the term "disqualified person" includes an agent of the taxpayer at the time of the transaction, such as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent within the two-year period ending on the date of the transfer of the first of the relinquished properties. The opinion in this case doesn't make specific mention of an additional disqualification, but it should be noted that even had the son not been related, he would have been disqualified as an agent of the taxpayer by serving as his attorney.
As to the issue concerning the taxpayer's basis in the relinquished property, the Tax Court held that Section 1.1041-1T(d), Q&A-10, Temporary Income Tax Regs., 49 Fed. Reg. 34453 (Aug. 31, 1984), provides specific guidance regarding such a transfer of property pursuant to divorce. The Reg. provides that the transferor of property under IRC Section 1041 recognizes no gain, loss, or change in basis upon the transfer even if it was in exchange for the release of marital rights or other consideration, regardless of whether the property is separately owned or is a division of community property. "In all cases, the basis of the transferred property in the hands of the transferee is the adjusted basis of such property in the hands of the transferor immediately before the transfer. Even if the transfer is a bona fide sale, the transferee does not acquire a basis in the transferred property equal to the transferee's cost (the fair market value). This carryover basis rule applies whether the adjusted basis on the transferred property is less than, equal to, or greater than its fair market value at the time of the transfer …"
Thus, the IRS prevailed in its determination that there was a deficiency of $1,366,993 in the taxpayer's 2008 Federal income tax and its imposition of an accuracy-elated penalty of $273,397.20. This case makes it crystal clear that taxpayers need to seek out a truly 'qualified' intermediary. One who not only fulfills the requirements for eligibility to serve as a QI under the Regs., but also one that is qualified to assist the taxpayer and the taxpayer's tax advisors concerning the potential pitfalls in structuring Internal Revenue Code Section 1031 deferred exchanges.