June 27, 2008--San Diego, California--The IRS's Office of Chief Counsel issued an informational
letter (INFO Letter No. 2008-0021) regarding the
income tax consequences of a failed 1031 exchange transaction due to the failure of the Qualified Intermediary
(also referred to as a QI) that was administering the 1031 exchange.
The IRS's Office of Chief Counsel was responding to an inquiry made by Congressman Delahunt of Massachusetts on behalf of his constituents that had lost money through a failed 1031 exchange transaction because their 1031 exchange Qualified Intermediary had embezzeled their 1031 exchange proceeds, failed and filed for bankruptcy law protection.
The constituents asked if they could still defer the depreciation recapture and capital gain on thei sale of their relinquished property when they were not able to acquire like-kind replacement property since their lost their 1031 exchange funds when their Qualified Intermediary failed.
The Internal Revenue Service first recited that the depreciation recapture and capital gain from the sale of the real estate investor's relinquished property is taxable under Section 61 of the Internal Revenue Code unless Section 1031 of the Internal Revenue Code applies.
It further stated that the 1031 exchange fails and any depreciation recapture and capital gain realized on the sale of the real estate investor's relinquished property must be recognized and reported if the Qualfied Intermediary (QI) fails to acquire like-kind replacement property and convey it to the real estate investor within 180 calendar days of the conveyance of the relinquished property.
The Internal Revenue Service's letter continues that if the real estate investor had sustained a loss during the taxable year (and that insurance does not cover), the real estate investor could write off the loss from income under Section 165(a)(1) of the Internal Revenue Code if the facts and circumstances surrounding the 1031 exchange transaction show that the real estate investor sustained the loss as a direct result of the actions of the failed Qualified Intermediary.
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