In Ocmulgee Fields, Inc. v. Commissioner, (March, 2009) the Tax Court rebuffed a taxpayer’s attempt to use an exchange intermediary to avoid certain related party restrictions on like-kind exchanges. IRC Section 1031generally provides that if business or investment property is exchanged for property of a “like-kind,” the exchanging taxpayer is allowed to defer recognizing his gain until he disposes of the property he received in the exchange. These exchanges are commonly used to dispose of income producing real property and acquire other income producing real property. However, IRC Section 1031(f) provides that a taxpayer’s gain is recognized if it does a Section 1031 exchange with a related party and either party then disposes of the property it acquired in the exchange within two years.

To try to avoid these rules, the taxpayer completed an exchange through a “qualified intermediary.” This is an independent party, often owned by a bank, escrow or title insurance company, which enables unrelated parties to complete deferred exchanges without having to trust each other. The taxpayer who wants to complete the exchange transfers his property to the intermediary who sells it to the third party that wants to buy it. The intermediary holds the cash from that sale until the exchanging taxpayer identifies his replacement property, at which time the intermediary purchases that property and transfers it to the exchanging taxpayer to complete his exchange. Recently, some of these intermediary companies have gone bankrupt or absconded with funds, but more on that later.

The taxpayer here transferred his property to an intermediary which then sold it to an unrelated party. However, the property that the taxpayer identified to complete the exchange was owned by a related party as defined in IRC Section 1031(f). The court held that this exchange ran afoul of IRC Section 1031(f)(4) which provides transactions structured to avoid the purpose of Section 1031(f) do not qualify as tax deferred exchanges. The court concluded that this provision allowed the transaction to be viewed as a direct exchange between the taxpayer and the related party, in effect ignoring the intermediary. Since the taxpayer’s original property was sold by the intermediary, it was deemed to have been sold by the related party, thus running afoul of the 2 year rule.

All like-kind exchanges are tricky and should be done with guidance from qualified advisors. This is especially true of deferred exchanges accomplished through the use of a qualified intermediary.

While on this subject, we must warn you to do your due diligence on any qualified intermediary you are considering using to complete a deferred like-kind exchange. People tend to think of these as “tax transactions” so they do not seem to worry about the money. It is just stunning how many people who would not loan their best friend $10 without a letter of credit will allow an intermediary they have never heard of to hold millions of dollars of their money without making any effort to determine the intermediary’s creditworthiness. Most of these firms are highly reputable but recent events have shown that is not uniformly so. Please do appropriate due diligence before selecting one of these firms to hold exchange proceeds. If one of them does steal your money, you should at least get a loss deduction to offset the gain you will now have to recognize because you did not complete your exchange.