HOW TO STRUCTURE LIKE-KIND EXCHANGES THROUGH A QUALIFIED INTERMEDIARY

With the recent upheaval around proposed regs dealing with the treatment of exchange funds held by qualified intermediaries (QI) in deferred like-kind exchanges, the complex nature of these transactions is in the spotlight.  QIs have served an important business/investment purpose since the Starker decision (Starker v. U.S., 602 F2d 1341, 79-2 USTC ¶9541) first approved of their participation.

Using QIs to structure like-kind transactions

The reliance on QIs for taxpayers seeking to engage in like-kind exchanges came about as a result of the Tax Court decision in Starker which allowed the taxpayer to identify and acquire replacement property from a third party; that is, not the party acquiring the taxpayer’s relinquished property.

In Starker, the taxpayer sold property to a buyer and used an agreement whereby the buyer would hold the funds to purchase replacement property for the taxpayer in order for the taxpayer to get the tax deferral benefits of a like-kind exchange.

The IRS originally said the transaction in Starker did not pass muster for a like-kind exchange claiming that like-kind exchanges were intended solely for direct property “swaps”.  The Tax Court and the Ninth Circuit Court of Appeals disagreed.  It took until 1991, however, for Treasury to issue regs to determine how the proceeds or funds received in a like-kind exchange that is not a straight up “swap” would be handled.

Treasury created a “safe harbor” for like-kind exchanges structured through QIs.  Since then, taxpayers have been using QIs to structure their like-kind exchange transactions.

• Comment.  The regs created other safe harbors, other than the QI safe harbor.  The other safe harbors include a safe harbor for qualified trusts and escrow accounts, for security and guarantee arrangements and for interest and other growth factors.

QI safe harbor

Under the QI exchange safe harbor, the taxpayer must identify replacement property within 45 days from the date the relinquished property is transferred and has a total of 180 days from the same date to acquire all replacement property.  In that period, the taxpayer may not hold or have access to the proceeds from the relinquished property.

Through the QI safe harbor, taxpayers will not be deemed to be actually or constructively in receipt of the proceeds from the relinquished property because exchanges structured through a QI will be treated as if the QI were not the agent of the taxpayer.  Money or other property received by the QI before the QI receives replacement property will not be treated as money or other property received by the taxpayer.  The taxpayer’s transfer of relinquished property and subsequent receipt of replacement property will be treated as an exchange and the determination of whether the taxpayer is in actual or constructive receipt of money or other property is made as if the QI is not the agent of the taxpayer.

Requirements for QIs

For taxpayers to be in the QI safe harbor, the following requirements must be met:

• Then QI must not be the taxpayer or a disqualified person;
• The QI must enter into a written agreement with the taxpayer under which the taxpayer’s right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI is expressly limited; and
• The QI must acquire relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer as required by the agreement.

Selecting the right QI

Like any other agent, taxpayers must be sure to look into a QI’s background, education, experience, and reputation.  In addition to that basic research, taxpayers must be aware that certain QIs are disqualified by the regs.

Disqualified personas include a taxpayer’s employees, attorneys, accountants, investment bankers or brokers, and real estate agents or brokers are disqualified if they have worked for the taxpayers within two years prior to the exchange.

Not disqualified are bank-owned exchange co9mpaines where the taxpayer has received banking services from the parent bank and financial institutions, title insurance companies, and escrow companies that have provided routine financial, title, escrow, or trust services for the taxpayer.

Increased cost of using QIs

The number of QIs available could diminish if the proposed regs dealing with exchange funds held by QIs in like-kind exchanges are adopted.

The proposed regs would change the treatment of exchange funds in exchanges structured through QIs.  The current regs dealing with exchange funds apply only to qualified escrow and qualified trust accounts and determine whether the taxpayer or the QI will be deemed the owner of the funds in these accounts under a flexible facts and circumstances test.  The new regs will regulate all exchange funds and treat the funds as if the taxpayer loaned them to the QI.  As a result, the QI will be deemed the owner of the funds, responsible for the tax consequences and the taxpayer will be deemed the owner only if all the earnings from the funds are paid over to the taxpayer.  In addition, the proposed regs would treat certain of the deemed loans from the taxpayer to the QI as below market loans and subject them to Code Sec. 7872.  Under Code Sec. 7872, the interest earned on these loans will be imputed to the taxpayer.

Comment.  Some independent QIs claim that the proposed changes will drive them out of business because they will create “phantom income” for taxpayers who will refuse to pay it, and as a result they will no longer be able to keep interest earnings, which comprise a large aprt of their revenues.

Information provided by Federal tax Weekly, June 22, 2006. Issue Number 25

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