The IRS today released an advance copy of Rev. Proc. 2010-14 which provides a safe harbor method of reporting gain (or loss) for certain taxpayers who initiate deferred like-kind exchanges under section 1031, but fail to complete the exchange because the qualified intermediary (QI) defaults on its obligation to acquire and transfer replacement property to the taxpayer.

For an electronic version of the revenue procedure (17 pages): Rev.Proc. 2010-14


Reason for Guidance
Rev. Proc. 2010-14 notes that there are situations when taxpayers initiated like-kind exchanges by transferring relinquished property to a QI, but were unable to complete these exchanges within the exchange period solely because the QI failed to acquire and transfer replacement property to the taxpayer (referred to by the IRS as a “QI default”).

The IRS explained that in many of these QI default situations, the QI entered into bankruptcy or receivership, thereby preventing the taxpayer from obtaining immediate access to the proceeds of the sale of the relinquished property.

The view of the IRS is that a taxpayer who, in good faith, sought to complete the exchange using the QI, but failed to do so because the QI defaulted on the exchange agreement and became subject to a bankruptcy or receivership proceeding, ought not be required to recognize gain from the failed exchange until the tax year when the taxpayer receives a payment attributable to the relinquished property.

Rev. Proc. 2010-14
An eligible taxpayer may report gain realized on the disposition of the relinquished property as the taxpayer receives payments attributable to the relinquished property using the “safe harbor gross profit ratio method.”

Rev. Proc. 2010-14 defines an eligible taxpayer as one who:

•                         Transferred property to a QI pursuant to a section 1031 like-kind exchange transaction

•                         Properly identified replacement property within the identification period (unless the QI default occurs during that period)

•                         Did not complete the like-kind exchange solely because of a QI default (involving a QI that becomes subject to a bankruptcy proceeding or a receivership proceeding under federal or state law)

•                         Did not have actual or constructive receipt of the proceeds from the disposition of the relinquished property or any property of the QI before the time when the QI entered the bankruptcy or receivership

If a QI defaults on its obligation to acquire and transfer replacement property, the IRS will treat the taxpayer as not having actual or constructive receipt of the proceeds during that period, provided that the taxpayer reports gain in accordance with the rules provided in Rev. Proc. 2010-14.

In general, gain will be recognized on the disposition of the relinquished property only as required under the “safe harbor gross profit ratio method” described in the revenue procedure. Under this method, the portion of any payment attributable to the relinquished property that is recognized as gain is determined by multiplying the payment by a fraction, the numerator of which is the taxpayer’s gross profit and the denominator of which is the taxpayer’s contract price.

Rev. Proc. 2010-14 defines several terms for purposes of applying the safe harbor gross profit ratio method, including: (1) payment attributable to the relinquished property; (2) gross profit: (3) selling price; (4) contract price; and (5) satisfied indebtedness.

The revenue procedure also sets forth rules for the treatment of satisfied indebtedness in excess of basis and the treatment of recapture income; the calculation of the amount of maximum gain to be realized and any loss deduction; as well as imputed interest determinations.

Examples illustrating the application of Rev. Proc. 2010-14 are provided.

Rev. Proc. 2010-14 will appear in Internal Revenue Bulletin 2010-12, dated March 22, 2010.