Identification Issues in Deferred and Reverse Exchanges

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August 22, 2018
Author: Derrick M. Tharpe
Organization: Wells Fargo


A. RE: Kreiser’s, Inc., et al. v. First Dakota Title Limited Partnership d/b/a First Dakota Title and d/b/a The Title Resource Network (SD 2nd Cir.)

In this case, the defendant, First Dakota Title (QI), was found negligent in performing its duty as qualified intermediary for Kreiser’s, Inc. (Taxpayer).

The Taxpayer intended to do an improvement exchange, but the replacement property was deeded directly to the Taxpayer rather than an EAT and the 45 day ID period passed. This eliminated the possibility of an improvement exchange. The QI was found negligent for failing to use reasonable care in determining the type of exchange necessary. This was the result of several acts by the QI: (1) The QI did not ask the right questions when the info call came in from the Taxpayer. The QI apparently assumed it was a “regular” exchange even though the Taxpayer would be trading down by over $320K, and the QI did not ask about any improvements; (2) The QI did not do parking arrangements, but did not advertise this, or put it in the transmittal letter to the QI; (3) The QI, also acting as closing agent, did not send the exchange documents to the Taxpayer ahead of the closing of the relinquished property. This eliminated the possibility that the Taxpayer’s advisors might have realized the error. It appears as though the QI had time to send out drafts before closing, but this was not its policy; (4) The QI had the Taxpayer sign the ID letter in blank. The QI later filled in the replacement property description, with no improvements listed, and did not mail a copy to the Taxpayer; (5) The replacement property closed a few days after the relinquished property, again with no copies of documents provided in advance to the Taxpayer or sent to the Taxpayer’s advisors. The Taxpayer was not given a copy of the deed or other documents till after the 45th day period had expired; and (6) There were excess exchange proceeds of $328K, yet the QI held on to the funds and asked no questions of the Taxpayer during the entire 45 day period.

The judge held that the QI owed a legal duty to provide professional services using such skill and care ordinarily exercised by others in the QI profession. The duty arose because the QI held itself out to the Taxpayer as being skilled in the facilitation of IRC § 1031 exchanges on behalf of its client, and it prepared the exchange documentation. The judge found that the QI breached that duty for the reasons listed above.

The judge rejected the QI’s argument that it had no liability because of indemnification language in the exchange documents. The language of the indemnification was ambiguous and was construed against the QI as the drafter. The judge also found there was no contributory negligence on the Taxpayer’s part because it was relying on the QI’s expertise to ask the right questions and structure the transaction correctly. The QI held itself out as being skilled and competent in IRC § 1031 exchanges. The Taxpayer did not have any expertise or in depth knowledge of IRC § 1031 exchanges. The Taxpayer was dependent upon the QI to properly structure and execute an IRC § 1031 exchange.

The total tax liability from the exchange was $172,804. This amount included a built in gains tax because the Taxpayer was an S corporation with built in gain. The judge did reduce the damages by the net present value of the Taxpayer’s future tax savings as the result of this increased depreciable basis.

A. In the Matter of the Appeal of Patricia Bragg, 2012 WL 7677806 (Cal.St.Bd.Eq.) (Nov.14, 2012)
In this decision, the California State Board of Equalization (BOE) upheld a California income tax and penalty assessment by the California Franchise Tax Board (FTB). The taxpayer in this case attempted a non safe harbor reverse exchange in the years 2004-5. The BOE also found the taxpayer liable for the California accuracy related penalty, which incorporates the provisions of IRC Section 6662, and provides for a penalty of 20 percent of the applicable underpayment. The BOE found the taxpayer had no exceptions to the penalty.

The BOE found that the “adequate disclosure and reasonable basis” exception did not apply to the accuracy-related penalty because the taxpayer had not fully disclosed the position by filing a Form 8824. The proper disclosure form was IRS Form 8275. Further, the BOE found that the taxpayer had not met the “reasonable basis” standard. The taxpayer asserted that the subject transaction “appears to qualify as tax-deferred” and “the authorities are essentially silent” on non safe harbor reverse exchanges. The BOE concluded her own statements indicated that she took a return position that was “merely arguable” and was not “reasonably based” on any legal authority.

Moreover, she cited no legal authority for the tax treatment of the gain on the return. Lastly, the BOE found that the taxpayer did not meet the reasonable cause and good faith exception to the accuracy-related penalty. She stated that she reasonably relied on a QI that was experienced in exchanges to advise her that the transaction would qualify. However, the BOE noted that this was directly contradicted by the representation made in the EAT Agreement and the Exchange Agreement, which expressly stated that the taxpayer obtained independent tax advice and neither the QI nor the EAT provided any tax advice or made any representations as to whether the transaction was in compliance with federal or state law as a tax-deferred exchange. Finally, the BOE noted that the taxpayer did not provide any details of the purported tax advice she received from any source to establish that her reliance was reasonable and that she acted in good faith.

B. Goolsby v. Commissioner (April 1, 2010); T.C. Memo. 2010-64
The Tax Court held that property acquired by the taxpayers in an IRC § 1031 exchange did not qualify as replacement property when the taxpayers moved into the property two months after acquiring it. The Tax Court found the taxpayer liable for the accuracy related penalty due to a  substantial understatement of tax. The taxpayers failed to present any evidence that they acted with reasonable cause and in good faith. The taxpayers did not use counsel and represented themselves.

The taxpayers asked the QI if they could move into the property if renters could not be found, and the court used this against the taxpayers. QIs this or similar questions from clients frequently. Qis should be careful with their answers and let the client know about the fate of the Goolsbys.

If a taxpayer’s exchange is disallowed, the taxpayer can be liable not only for the income tax related to the disposition of the relinquished property, but also penalties and interest.§ 6601 imposes interest on an underpayment of taxes at a rate equal to the federal short term rate plus 3%.

A. Accuracy Related Penalties. IRC § 6662 imposes an accuracy related penalty equal to 20 percent of the amount of the underpayment of tax. With respect to an IRC § 1031 exchange, the penalty could be assessed unless (i) there is substantial authority for the IRC § 1031 position, or (ii) the relevant facts are adequately disclosed on the tax return and there is a reasonable basis for the position. Reg. 1.6662-4 Alternatively, the penalty can be avoided if the taxpayer has reasonable cause and good faith for the position if it does not satisfy either of two exceptions. IRC 6664(c) The penalty can also be assessed in an exchange if there is negligence or disregard of regulations or rules. IRC 6662(b) The taxpayer in Goolsby v. Comm. T.C. Memo. 2010-64 was assessed the accuracy related penalty.

1. Substantial Authority. The penalty can be avoided if the taxpayer has substantial authority for the position taken in the exchange. It is less stringent than the more likely than not standard (which means there is a greater than 50-percent likelihood of the position being upheld), but more stringent than the reasonable basis standard, as defined below. The substantial authority exception can be met when the taxpayer has less than a 50%, but more than a one-in-three chance of being sustained. Reg. 1.6662-4(d)(3) The possibility that a return will not be audited, or that an item will not be raised on audit, is not relevant in determining whether the substantial authority standard (or the reasonable basis standard) is satisfied. Reg. 1.6662-4(d)(3)(iii) Substantial authority may only be based on the following: (i) the Internal Revenue Code and other statutory provisions; (ii) proposed, temporary and final regulations construing such statutes; (iii) revenue rulings and revenue procedures; (iv) tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; (v) court cases; (vi) congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers; (vii) General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); (viii) private letter rulings and technical advice memoranda issued after October 31, 1976; (ix) actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); (x) Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Reg. 1.6662-4(d)(3)(iii)

Substantial authority does not include conclusions reached in treatises (including this outline), legal periodicals, legal opinions or opinions rendered by tax professionals. Nor does it include any authority that is overruled or modified, implicitly or explicitly. A Tax Court opinion is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin. Reg. 1.6662-4(d)(3)(iii)

The type of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one and if one of these documents is more than 10 years old, it is generally is accorded very little weight. A taxpayer also may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision. Reg. 1.6662-4(d)(3)(iii)

2. Disclosure and Reasonable Basis. The accuracy related penalty can also be avoided in an exchange if the position is disclosed and the taxpayer has ‘reasonable basis’ for the position. “Reasonable basis” is a lesser standard than ‘substantial authority’ but is significantly higher than not frivolous or not patently improper. It must be more than merely arguable or merely a colorable claim. If a return position is reasonably based on one or more of the authorities described above under “substantial authority”, the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard.  Disclosure is adequate on a return if the disclosure is made on a properly completed form attached to the return. While the IRS issues a list of forms considered adequate for the purposes of disclosure, Form 8824 is not on the list. Rev. Proc. 2001-11 Therefore, if the position is not contrary to a regulation, disclosure must be made on Form 8275 (Disclosure Statement). If the position is contrary to a regulation, disclosure must be made on Form 8275-R (Regulation Disclosure Statement) Reg. 1.6662-3(c)

3. Reasonable Cause and Good Faith. The penalty may also be avoided if the taxpayer had reasonable cause for the position taken with respect to the exchange and acted in good faith. IRC § 6664(c); Reg. 1.1664-4(a) This determination is made on a case-by-case basis, taking into account all pertinent facts and circumstances, with the most important factor being the extent of the taxpayer's effort to assess the proper tax liability. For a taxpayer to rely reasonably upon advice so as possibly to negate an accuracy-related penalty, the taxpayer must prove that the taxpayer meets each requirement of the following three-prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment. See Ellwest Stereo Theatres, Inc. v. Commissioner, T.C.Memo. 1995-610 The taxpayers in DeCleene and Ocmulgee Fields, Inc. avoided the accuracy related penalty for a disallowed exchange by relying on the advice of a CPA. Decleene v. Comm., 115 TC 457 (2000); Ocmulgee Fields, Inc. v. Comm. (11th Circui, 2010) affirming 132 TC 6 (2009) Can the taxpayer rely on the advice of the QI to avoid a penalty if the QI is not otherwise an attorney or CPA? Most QIs specifically state that they are not giving tax advice and would not consider themselves “professional tax advisors”, yet they advertise their ‘expertise’ in exchange transactions. Often, the QI is only person the taxpayer consults with respect to the exchange. Perhaps reliance would depend on the taxpayer’s sophistication. A more sophisticated taxpayer would be expected to obtain written advice from its tax attorney or CPA to come within the good faith reliance exception whereas a less sophisticated taxpayer could use good faith reliance on the advice of the QI to avoid the penalty. The issue is yet to be litigated.

4. Negligence and Disregard of Regulation. The penalty may be assessed for negligence, including the failure to make a reasonable attempt to comply with the provisions of IRC § 1031. The taxpayer is negligent if the taxpayer takes a position without a reasonable basis, as discussed above. The taxpayer must also keep adequate books and records to substantiate positions properly. Reg. 1.6662-3(b)(1)

The penalty also applies if the taxpayer’s position if contrary to rule or regulation and the taxpayer carelessly, recklessly or intentionally disregards the rule or regulation. Reg. 1.6662-3(b)(2) Rules include revenue rulings and notices issued by the IRS. For example, the penalty could be applied if the taxpayer fails to conform to the identification requirements in an exchange found in the regulations, or for a related party transaction contrary to Revenue Procedure 2002-83. The penalty can be avoided for the position if the taxpayer discloses the position and has a reasonable basis for the position, as discussed above under Disclosure and Reasonable Basis. A taxpayer who takes a position contrary to a revenue ruling or notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits.

B. Fraud Penalties. IRC § 6663(a) imposes a fraud penalty of 75% of the underpayment attributable to the fraud if the exchange constitutes an intent to evade tax or intent to deceive. In the case of Dobrich, the taxpayer backdated his 45 day identification letter and was assessed the fraud penalty. Dobrich v. Comm., TC Memo 1997-477

A. State Bar Association Rules. Each State Bar Association has rules of professional conduct that generally obligate the members of the Bar to act in a professional manner, obey the law, avoid conflicts of interest, and to put the interests of clients ahead of their own interests. What if the client wants to take a frivolous position regarding an exchange, or worse yet, report an exchange in which the attorney knows the client lied on ID form. T w o o f t h e m o r e c o mmo n q u e s t i o n s applicable to an IRC§ 1031 exchange.
1. Does a QI engage in the unauthorized practice of law?
2. What if the attorney knows the client did not properly identify by the 45th day, but is still proceeding with the exchange?

A. State Laws.
In response to the QI bankruptcies in 2007 through 2011, California, Nevada, Washington, Oregon, Maine, Virginia, Colorado and Connecticut have enacted laws governing exchange facilitators. Cal. Fin. Code sec. 51000-51015; Rev. Code Wa. 19.70; Co. Rev. Stat. 6-1-7; Nev. Rev. Stat. 645G and 205.960; Me. Rev. Stat. Ann. Tit. 10 Sec. 212-C; Sec. 1-7, Ch. 858, Oregon Laws 2009; Va. Code Ann. Sec.55-517; CT Pub. Act 13-135. Idaho has ruled that its escrow act applies to exchange intermediaries. Id. Code sec. 30-901 et seq. Policy Statement #2007-4. Each state’s law should be examined for specific provisions, but the laws generally apply to all exchange facilitators considered to be “doing business” in the state. “Doing business” means the relinquished property in the exchange is located in the state, or the “exchange accommodation titleholder” holds property in the state. It also applies to someone who maintains an office in the state. An “exchange facilitator” is a qualified intermediary, exchange accommodation titleholder, qualified trustee, or qualified escrow holder, other than a bank or title company acting solely as a qualified escrow holder or qualified trustee.

The laws contain provisions for notification to clients if the exchange facilitator has a change of ownership, defined as a more than a 50% change in ownership. Also, exchange facilitators must maintain: (1) a fidelity bond of at least $1,000,000, or a deposit of cash, securities or a letter of credit for at least $1,000,000, or use a qualified escrow or trust that provides that any withdrawals from that escrow account or trust require the exchange facilitator’s and the client’s written authorization; and (2) an errors and omissions insurance of at least $250,000, or cash, securities or a letter of credit letter in that amount. The amount of the fidelity bond in Maine is $250,000. Virginia does not have a fidelity bond requirement.

With respect to the exchange funds, the laws (other than Idaho and Virginia) generally provide that the exchange facilitator must act as a custodian of the exchange funds and meet the “prudent investor” standard in investment of funds, and satisfy investment goals of liquidity and preservation of principal. The exchange facilitator may not comingle exchange funds with operating accounts, or loan or transfer funds to an affiliate (other than to an affiliate financial institution or to an exchange accommodation titleholder pursuant to the exchange contract). The laws also provide exchange funds are not subject to execution or attachment on any claim against the exchange facilitator.

The Washington law also requires that the exchange facilitator either: (1) hold the exchange funds in a qualified escrow or trust with the funds deposited in a financial institution, and the account must provide that a withdrawal or other transfer requires the exchange facilitator and the taxpayer to independently authenticate a record of the transaction; or (2) the exchange facilitator must maintain a bond in an amount of not less than $1,000,000 for the benefit of a client of the exchange facilitator that suffers a loss as a result of the exchange facilitator's covered dishonest act.

The bond must cover the acts of employees of an exchange facilitator and owners of a non publicly traded exchange facilitator. All exchange accounts must be held in a separately identified account, as defined in Reg.§ 1.468B-6(c)(ii), the client must receive all the earnings credited to the separately identified account and the client must receive independently from the depository financial institution, by any commercially reasonable means, a current statement for verification of the deposited exchange funds. Furthermore, the exchange facilitator must provide the client with written notification of how the exchange proceeds have been invested or deposited. The exchange facilitator must disclose on the company web site and contractual agreement the following statement in large, bold, or otherwise conspicuous typeface calculated to draw the eye:


If recommending other products or services, the exchange facilitator must disclose to the client that the exchange facilitator may receive a financial benefit, such as a commission or referral fee, as a result of such recommendation. The exchange facilitator must not recommend or suggest to a client the use of services of another organization or business entity in which the exchange facilitator has a direct or indirect interest without full disclosure of such interest at the time of recommendation or suggestion. An exchange facilitator must provide evidence to each client that these requirements are satisfied before entering into an exchange agreement. An exchange facilitator must also administer its business under the direct management of an officer or an employee who is either: (1) An attorney or certified public accountant admitted to practice in any state or territory of the United States; or (2) A person who has passed a test specific to the subject matter of exchange facilitation. RCW 19.70

The Colorado law requires that exchange funds in excess of $250,000 must be invested or deposited in such a manner as to require both the taxpayer’s and the exchange facilitator’s commercially reasonable means of authorization for withdrawal, including the taxpayer’s delivery to the exchange facilitator of the taxpayer’s authorization to disburse funds and the exchange facilitator’s delivery to the depository of the exchange facilitator’s authorization to disburse exchange funds; or delivery to the depository of both the taxpayer’s and the exchange facilitator’s authorizations to disburse exchange funds. Exchange funds that are aggregated into common investments must be readily identifiable by the financial institution as to each taxpayer for whom they are held through an accounting or subaccounting system. An exchange facilitator must also provide the taxpayer with written notification of the manner in which the exchange funds will be invested or deposited. Co. Rev. Stat. 6-1-7

Exchange funds in Nevada must be invested as a fiduciary. They must be deposited in FDIC insured or private insured account, and designated as “trust funds” or “escrow accounts.” They also must be deposited into a qualified escrow account or qualified trust as defined in 26 C.F.R. §1.1031(k)-1(g)(3), and the money must be held in such a manner that it may not be withdrawn from the qualified escrow account or qualified trust without the written approval of the intermediary and the client. A person who violates the provisions of this section is guilty of a category D felony, and must pay a civil penalty of not less than $10,000. Nev. Rev. Stat. 205.960 Nevada also requires the licensing of exchange facilitators and is promulgating regulations to provide for such licensing.

Idaho law requires an exchange intermediary to register in Idaho as an escrow agent. A separate escrow trust account must be maintained for each client at a financial institution authorized to conduct business in Idaho. Assets must be maintained to “reasonably preserve and protect the property from loss, theft or damage, and which otherwise comply with all duties and responsibilities of a fiduciary”. Idaho Code sec. 30-901 et seq. Policy Statement #2007-4 Maine law requires licensing for exchange facilitators. 10 MRSA c. 212-C Virginia requires that all exchange funds be placed in a separately identified deposit account, and that the taxpayer be required to approve all withdrawals from the account. Alternatively, the exchange funds can be placed in a qualified escrow or qualified trust account. The exchange funds must be in a deposit account with a financial institution, such as a money market or checking account, unless another investment is expressly requested by the taxpayer. 55 Code of Vir.

The various state laws provide that exchange facilitators must not engage in various acts, such as material representations, false advertising, failure to account for moneys or property, failure to return exchange funds to clients, fraud, criminal conduct, etc. While the California, Oregon, Maine, Virginia, Connecticut and Colorado laws only impose civil penalties, the Washington, Nevada and Idaho laws impose criminal penalties.

In Nebraska, a title insurance agent who holds funds relating to an exchange must provide written disclosure, at or before closing, to the taxpayer, on a separate paper with no other information on the paper [Emphasis added] which states that: (i) Such services performed by a title insurance agent are not regulated by the Department of Banking and Finance, the Department of Insurance, or other agency of the State of Nebraska or by any agency of the United States Government; (ii) The safety and security of such funds is not guaranteed by any agency of the State of Nebraska or of the United States Government or otherwise protected by law; and (iii) The owner of such funds should satisfy himself or herself as to the safety and security of such funds. Section 44-19,116(1) (f), Nebraska Revised Statutes

B. Federation of Exchange Accommodators (FEA) Code of Ethics and Conduct. The code is available at Selected excerpts:

Protection of the public against fraud, misrepresentation, and other illegal practices in the Exchange Accommodator profession shall be the duty and responsibility of each Exchange Accommodator member of the FEA, and shall not actively participate in such fraud, misrepresentation or other illegal practices. An Exchange Accommodator shall not commit acts of fraud, embezzlement, misappropriation of funds, conversion of the property of another, theft, forgery or such similar acts as may be defined by local, state or federal law. An Exchange Accommodator who is convicted of such an act, or enters a plea of "guilty", "no contest", "nolo contendere" or similar shall immediately notify the Board of Directors of the FEA, in writing. An Exchange Accommodator who holds any other professional designation or license, whose designation or license is suspended or revoked, or  who voluntarily relinquishes such designation or license, due to activities concerning fraud, embezzlement, misappropriation of funds, conversion of the property of another, theft, forgery or any crime (misdemeanor or felony) shall immediately notify the Board of Directors of the FEA, in writing of such. An Exchange Accommodator shall not voluntarily participate in any act which it knows to be unlawful or against the standard of conduct set forth in this Code of Ethics and Conduct, even if directed to do so by the client, his/her/its agent, or advisor. It shall be the duty of every Exchange Accommodator to protect the reputation of the profession by exposing those engaged in such practices.

An Exchange Accommodator who is not licensed to practice law, accountancy, or other licensed or regulated profession shall not engage in activities which constitute such practice. The Exchange Accommodator shall recommend in all cases that the parties involved in an exchange transaction seek tax and legal counsel.

If recommending other products or services, the Exchange Accommodator shall disclose to the client that it may receive a financial benefit, such as a commission or referral fee, as a result of such recommendation. The Exchange Accommodator shall not recommend or suggest to a client the use of services of another organization or business entity in which they have a direct or indirect interest without full disclosure of such interest at the time of recommendation or suggestion. At no time shall an Exchange Accommodator accept any illegal payment of any kind whatsoever.

It is the duty of an Exchange Accommodator to disclose to its clients those circumstances, relationships, and interests, if any, which might constitute a conflict of interest. This disclosure shall be made when the Exchange Accommodator knows or learns of the conflict of interest.

A. Accounting for Monies and Property:
(a) Every Exchange Accommodator shall have the responsibility to act as a custodian for all exchange funds, being money, property, other consideration or instruments received by the Exchange Accommodator from, or on behalf of the client, except funds received as the Exchange Accommodator’s compensation. Every Exchange Accommodator shall invest exchange funds in investments which meet the “Prudent Investor Standard” and satisfy investment goals of liquidity and preservation of principal. For purposes of this section, the “Prudent Investor Standard” shall be violated if:
(1) Exchange funds are knowingly commingled by the Exchange Accommodator with the operating accounts of the Exchange Accommodator; or
(2) Exchange Funds are loaned or otherwise transferred to any person or entity affiliated with or related to the Exchange Accommodator except that this subsection shall not apply to a transfer or loan made to a financial institution which is the parent of or related to the Exchange Accommodator or to a transfer from an Exchange Accommodator to an EAT as required under the exchange contract; or
(3) Exchange funds are invested in a manner that does not provide sufficient liquidity to meet the Exchange Accommodator’s contractual obligations to its clients and does not preserve the principal of the exchange funds.

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