During the past year 1031 Exchange accommodation businesses or Qualified Intermediaries (QI's) engaged in 1031 tax free exchanges have been under scrutiny as a result of several recent companies closing their doors and leaving with taxpayer funds. Uneasiness within the industry has increased with news that many major banks are on shaky ground. The Federation of Exchange Accommodators (FEA) is the only trade organization for Qualified Intermediaries. In addition they play a huge role in lobbying for legislative issues to preserve the 1031 industry and to raise the comfort level of its clients. The FEA has been busy lobbying for industry regulation for QI's that would set industry standards for the manner in which client funds are held.

The U.S. Department of Treasury publishes regulations from time to time that provide rules and guidelines for the mechanics of a 1031 exchange. One such regulation, Sec 1.1031(k)-1(g), states that funds from relinquished property are required to be held by a Qualified Intermediary. However, the regulations do not specify how those funds are to be held, just that the taxpayer cannot take actual or constructive receipt of those funds. The Federation of Exchange Accommodators (FEA), the trade association for 1031 Exchange accommodation companies, has written the Treasury Department and requested a change in the regulations regarding the manner in which exchange funds are held. Basically, the requested change calls for new rules that would require relinquished funds to be deposited in a qualified trust account. Statewide Title Exchange Corp. (STEC) has obtained permission from the FEA to publish the requested rules change along with the proposed change in the Safe Harbor rules and it is our pleasure to be able to present this new information to our clients. The new rules will add an extra layer of protection to the client by requiring exchange funds be held in escrow accounts that do not expose them to risk. Statewide Title Exchange Corp. (STEC) has always as a matter of practice kept client funds in federally insured interest bearing bank accounts. We never invest your funds in risky accounts or speculative stock funds or securities. We welcome the new rules and the added security they bring to our industry.

STEC thanks you for the continued confidence you have placed in us over the years. As always, should you have any questions about you 1031 exchanges please do not hesitate to contact one of our Exchange Professionals at STEC.

-Reprinted Letter Follows-

CAPITOL TAX PARTNERS
June 2, 2008

Internal Revenue Service
Attn: CC:PA:LPD:PR (Notice 2008-47)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Notice 2008-47 (Guidance Priority List)

Dear Sir or Madam:

In response to Notice 2008-47 requesting items for inclusion on the 2008-09 Priority Guidance Plan, we respectfully suggest that you publish guidance that would modify the safe harbors provided in Treasury regulation section 1.1031(k)-1(g).

Under present law, Treasury regulation section 1.1031(k)-1(g) provides that a taxpayer undertaking a deferred like-kind exchange described in section 1031 will not be deemed to be in actual or constructive receipt of certain exchange funds if the taxpayer meets certain safe harbors. These safe harbors involve the deposit of the funds pursuant to an agreement in a qualified escrow account or a qualified trust (section 1.1031(k)-1(g)(3)) or with a qualified intermediary (section 1.1031(k)-1(g) (4)) (hereinafter, collectively, "safe harbor agreement"). The regulations do not require the safe harbor agreement to specify how the exchange funds may be held or invested by the escrow account holder, trustee or qualified intermediary (hereinafter, collectively, "intermediary").

On behalf of the Federation of Exchange Accommodators ("FEA"),¹ we request that Treasury regulation section 1.1031(k)-1 (g) be modified to require that any safe harbor agreement to deposit money or other property in a qualified escrow account or qualified trust or with a qualified intermediary specify that such funds or property be held or invested in a manner that satisfies the investment goals of liquidity and preservation of capital. Moreover, the safe harbor agreement must prohibit (1) the commingling of the exchange funds with the operating accounts of the intermediary, and (2) the lending or other transfer of the funds to a party related to the intermediary (other than to an affiliated bank or to an exchange accommodation titleholder pursuant to a qualified exchange accommodation arrangement for the taxpayer, as described in Revenue Procedure 2000-37). Attached to this letter is suggested language for the modifications to Treasury regulation section l.1031(k)-l(g).

The suggested modifications are supported by strong tax policy and administrative principles. Under present law, section 1031 provides that gain or loss is not recognized on the exchange of certain property if such property is exchanged solely for property of a like kind. Section 1031(a)(3) provides that the exchange of the like-kind properties need not be simultaneous, but that the property be identified and the exchange be completed within a relatively short period of time (45 and 180 days, respectively). Nonrecognition treatment under section 1031 is premised on the tax policy that a taxpayer should not be subject to tax when his or her economic position has not changed.

The safe harbors of the section 1031 regulations reflect this policy by providing that the taxpayer undertaking a deferred exchange not have access to the exchange funds (sections 1.1031(k)-1(g)(3)(ii)(B) and (iii)(B) and section 1.1031(k)-1(g)(4)(ii)), and may only benefit economically by interest or a "growth factor" in the nature of interest with respect to the investment or deposit of the funds (sections 1.1031(k)-1(g)(5) and 1.1031(k)-1(h)). Thus, section 1031 and the regulations contemplate that proceeds from the relinquished property will be used in a timely manner to acquire the replacement property and may accrue earnings, but those earnings must be in the nature of interest from the investment in cash or cash equivalents for a temporary period. Section 1031 and the safe harbors do not contemplate that a taxpayer may sell investment property (the relinquished property), invest the sales proceeds in risky or speculative investments such as stock or securities or in an enterprise, and then re-invest in another investment property (the replacement property).

The proposed modifications further the underlying policies of section 1031 and the safe harbors. The modifications would require the safe harbor agreement to provide that the exchange funds will be held or invested so that they are available, in whole, to complete the contemplated exchange quickly and seamlessly. The modifications contemplate that the exchange funds would not be subject to risks usually associated with investment activities, regardless of whether the investment is directed by the taxpayer or an intermediary.

Further, under the proposed modifications, certain uses of the exchange funds would be prohibited per se by the safe harbor agreement. These uses involve the use of exchange funds by the intermediary either directly in its operational accounts or indirectly by loans to affiliates. These prohibitions are motivated, in part, by the recent financial failures of certain intermediaries. In these cases, taxpayers lost their exchange funds and could not complete their deferred exchanges. The proposed modifications would help to avoid future losses by insuring that exchange funds are not exposed to the enterprise risk of an intermediary or its affiliates, and are not directed by the taxpayer or the intermediary into risky or speculative investments.

Adoption of the proposed modifications will aid tax administration, strengthen faith in the tax system, not create any new complexities for the IRS or taxpayers, and be easily implemented. The recent financial failures of certain intermediaries raised several difficult tax issues for taxpayers, their advisors, and the IRS. The proposed modifications to the section 1031 regulations should lessen the likelihood of future financial failures by qualified intermediaries and help avoid these difficult issues.

For many taxpayers, a deferred like-kind exchange is a one-time or infrequent event. These taxpayers may be relatively unsophisticated tax-wise and place their trust in an intermediary to guide them through the transaction. The recent intermediary financial failings may have shaken this trust not only in the individual firms involved, but also in the tax system as a whole. Adoption of the proposed modifications should help restore taxpayer confidence by reducing the possibility of future defaults.

Adoption of the proposed modifications will not create new burdens for the IRS or taxpayers. The modifications would require that the safe harbor agreement provide that the exchange funds will be held or invested in a manner that meets the investment goals of liquidity and capital preservation. The IRS will not need to inquire how the funds were actually held or invested or whether the goals were achieved. The only relevant inquiry is whether the safe harbor agreement called for the required investment standard. If the safe harbor agreement contains a provision that meets the standard, but the funds are not appropriately held or invested, the exchange will still qualify under section 1031 (assuming all other requirements are met). In these cases, the taxpayer may have a cause of action against the intermediary for breach of contract.

Adoption of the proposed modifications will not create significant new burdens for intermediaries, Almost all intermediaries currently hold or invest exchange funds with the investment goals of liquidity and capital preservation. Requiring this best practices standard in the regulations will not be burdensome.

Thank you for your consideration of this matter. We would be happy to meet with you to discuss this important issue in greater detail. In the meantime, if you have any questions or comments, please do not hesitate to contact the undersigned.

----------------------

¹The FEA is the only national trade organization formed to represent qualified intermediaries, their primary legal/tax advisors, and affiliates who are directly involved in IRC section 1031 exchanges. Formed in 1989, the FEA was organized to promote the discussion of ideas and innovations in the industry, to establish and promote ethical standards of conduct for the industry, to offer education to both the exchange industry and the general public, and to work toward the development of uniformity of practice and terminology within the exchange profession.

Sincerely,
Joseph M. Mikrut
Joseph M. Mikrut

Attachment

cc:
The Honorable Eric Solomon The Honorable Donald Korb
Assistant Secretary (Tax Policy) Chief Counsel
Department of the Treasury Internal Revenue Service
Ms. Karen Gilbreath-Sowell Ms. Clarissa Potter
Deputy Assistant Secretary (Tax Policy) Deputy Chief Counsel
Department of the Treasury Internal Revenue Service
Mr. Eric San Juan Mr. Edward S. Cohen
Tax Legislative Counsel Deputy Assoc. Chief Counsel
Department of the Treasury Internal Revenue Service
Mr. Dennis Tingey Ms. Donna Crisalli
Attorney-Advisor Senior Technical Reviewer
Department of the Treasury Internal Revenue Service

MODIFY REQUIREMENTS FOR WRITTEN SAFE HARBOR AGREEMENT BY ADDING NEW SECTION (g)(6)(iv); MODIFY SECTIONS (g)(3)(ii)(B), (g)(3)(iii)(B), (g)(4)(ii) and (g)(6)(i) TO REFERENCE NEW (g)(6)(iv) (Changes in italics)

(g) SAFE HARBORS
(1) IN GENERAL.
Paragraphs (g)(2) through (g)(5) of this section set forth four safe harbors the use of which will result in a determination that the taxpayer is not in actual or constructive receipt of money or other property for purposes of section 1031 and this section. More than one safe harbor can be used in the same deferred exchange, but the terms and conditions of each must be separately satisfied. For purposes of the safe harbor rules, the term "taxpayer" does not include a person or entity utilized in a safe harbor (e.g., a qualified intermediary). See paragraph (g)(8), Example 3 (v), of this section.

(2) SECURITY OR GUARANTEE ARRANGEMENTS. [not included]
...

(3) QUALIFIED ESCROW ACCOUNTS AND QUALIFIED TRUSTS.
(i) In the case of a deferred exchange, the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like-kind replacement property will be made without regard to the fact that the obligation of the taxpayer's transferee to transfer the replacement property to the taxpayer is or may be secured by cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow account or in a qualified trust.
(ii) A qualified escrow account is an escrow account wherein --
(A) The escrow holder is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section), and
(B) The escrow agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account, and expressly limits the escrow holder’s rights to hold and invest the money or other property held by the escrow holder, all as provided in paragraph (g)(6) of this section.
(iii) A qualified trust is a trust wherein --
(A) The trustee is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section, except that for this purpose the relationship between the taxpayer and the trustee created by the qualified trust will not be considered a relationship under section 267(b)), and
(B) The trust agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held by the trustee, and expressly limits the trustee's rights to hold and invest the money or other property held by the trustee, all as provided in paragraph (g)(6) of this section.
(iv) Paragraph (g)(3)(i) of this section ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the qualified escrow account or qualified trust. Rights conferred upon the taxpayer under state law to terminate or dismiss the escrow holder of a qualified escrow account or the trustee of a qualified trust are disregarded for this purpose.
(v) A taxpayer may receive money or other property directly from a party to the exchange, but not from a qualified escrow account or a qualified trust, without affecting the application of paragraph (g)(3)(i) of this section.

(4) QUALIFIED INTERMEDIARIES.
(i) In the case of a taxpayer’s transfer of relinquished property involving a qualified intermediary, the qualified intermediary is not considered the agent of the taxpayer for purposes of section 1031(a). In such a case, the taxpayer's transfer of relinquished property and subsequent receipt of like-kind replacement property is treated as an exchange, and the determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like-kind replacement property is made as if the qualified intermediary is not the agent of the taxpayer.
(ii) Paragraph (g)(4)(i) of this section applies only if the agreement between the taxpayer and the qualified intermediary expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary, and expressly limits the qualified intermediary's rights to hold and invest the money or other property held by the qualified intermediary, all as provided in paragraph (g)(6) of this section.
(iii) A qualified intermediary is a person who
(A) Is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section), and
(B) Enters into a written agreement with the taxpayer (the "exchange agreement") and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.
(iv) Regardless of whether an intermediary acquires and transfers property under general tax principals, solely for purposes of paragraph (g)(4)(iii)(B) of this section --
(A) An intermediary is treated as acquiring and transferring property if the intermediary acquires and transfers legal title to that property,
(B) An intermediary is treated as acquiring and transferring the relinquished property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person, and
(C) An intermediary is treated as acquiring and transferring replacement property if the intermediary (either on its own behalf or as the agent of any party to the transaction) enters into an agreement with the owner of the replacement property for the transfer of that property and, pursuant to that agreement, the replacement property is transferred to the taxpayer.
(v) Solely for purposes of paragraphs (g)(4)(iii) and (g)(4)(iv) of this section, an intermediary is treated as entering into an agreement if the rights of a party to the agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property. For example, if a taxpayer enters into an agreement for the transfer of relinquished property and thereafter assigns its rights in that agreement to an intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the transfer of the relinquished property, the intermediary is treated as entering into that agreement. If the relinquished property is transferred pursuant to that agreement, the intermediary is treated as having acquired and transferred the relinquished property.
(vi) Paragraph (g)(4)(i) of this section ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. Rights conferred upon the taxpayer under state law to terminate or dismiss the qualified intermediary are disregarded for this purpose. (vii) A taxpayer may receive money or other property directly from a party to the transaction other than the qualified intermediary without affecting the application of paragraph (g)(4)(i) of this section.

(5) INTEREST AND GROWTH FACTORS. [Not included]
...

(6) ADDITIONAL RESTRICTIONS ON SAFE HARBORS UNDER PARAGRAPHS (g)(3) THROUGH (g)(5).
(i) An agreement limits a taxpayer's rights as provided in this paragraph (g)(6) only if the agreement provides that the taxpayer has no rights, except as provided in paragraphs (g)(6)(ii) and (g)(6)(iii) of this section, to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period, and expressly limits the rights of the escrow holder, trustee or qualified intermediary to hold and invest the money or other property held as provided in paragraph (g)(6)(iv) of this section.
(ii) The agreement may provide that if the taxpayer has not identified replacement property by the end of the identification period, the taxpayer may have rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property at any time after the end of the identification period.
(iii) The agreement may provide that if the taxpayer has identified replacement property, the taxpayer may have rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property upon or after --
(A) The receipt by the taxpayer of all of the replacement property to which the taxpayer is entitled under the exchange agreement, or
(B) The occurrence after the end of the identification period of a material and substantial contingency that --
(1) Relates to the deferred exchange,
(2) Is provided for in writing, and
(3) Is beyond the control of the taxpayer and of any disqualified person (as defined in paragraph (k) of this section), other than the person obligated to transfer the replacement property to the taxpayer. (iv) The agreement must expressly provide that all cash or cash equivalents held by the escrow holder, trustee or qualified intermediary must be held in a manner that provides liquidity and preserves principal, and if invested, must be invested in a manner that satisfies investment goals of liquidity and preservation of principal. The agreement must expressly prohibit commingling of money held in the exchange account with the operating accounts of the escrow holder, trustee, or qualified intermediary, and lending or other transfer of money held in the exchange account to a party related to the escrow holder, trustee, or qua fl/led intermediary, other than an affiliated bank or an "exchange accommodation titleholder" for the purposes of an exchange by the taxpayer under Revenue Procedure 2000-37.

By Chris Burti, President, Statewide Title Exchange Corporation

For some time now, the IRS has been going through the process of promulgating a final regulation governing the tax treatment of the interest earned on funds held in a qualified escrow account or by a Qualified Intermediary under Sections 468B and 7872. The IRS has taken the position that the money that is held by an exchange facilitator as part of a deferred exchange should be treated as a loan by the taxpayer to the exchange facilitator. As such, the loan would be subject to imputed interest rules and the loan must be tested under section 7872 to determine whether it is a below-market loan for purposes of that section. The proposed regulations would have provided that a taxpayer must use a special 182-day applicable Federal rate (AFR) to test whether an exchange facilitator loan is a below-market loan. If an exchange facilitator loan was a below-market loan, the loan would be treated as a compensation-related loan that is not exempt as a loan without significant tax effect under Section 7872. Thus the taxpayers would be charged and taxed for income they had not received where the exchange facilitator retained any of the interest on the account which is a common practice in the industry.

Under the final regulations, if exchange funds are treated as being loaned by the taxpayer to the Qualified Intermediary, interest will be imputed to the taxpayer under section 7872 unless the exchange facilitator pays "sufficient interest". If the Qualified Intermediary does not provide for sufficient interest and the loan is not otherwise exempt from section 7872, interest income will be imputed to the taxpayer. Therefore, Qualified Intermediaries will be required to keep records of the amount of income paid to a taxpayer and may be required to report the income on Forms 1099 if not otherwise reported. The IRS estimated that most small businesses subject to the proposed regulations currently maintain records of the amount of income paid to the taxpayer and report the payments on Forms 1099. They concluded that the proposed regulations would not significantly increase the compliance burden of keeping records and reporting income paid to taxpayers. The exchange industry provided a study that showed that the added workload to comply with the proposed regulations is substantial and the software needed to comply with the recordkeeping requirements is not available at a cost affordable to many small businesses. Those commenting on the proposed regulations complained that the loan characterization rules would cause a large number of small businesses to suffer a substantial revenue loss and to fail or reduce their workforces. They claimed that small Qualified Intermediaries would be disproportionately affected because many often retain all or some, of the interest earned on the funds held in the exchange accounts. Obviously, if these businesses were required to impute interest on exchange funds, their customers would demand that this interest be paid to them. They assert that because bank-affiliated Qualified Intermediaries earn profits by means of credits that are not attributed to exchange funds, bank-affiliated Qualified Intermediaries will not be required to raise fees, creating an economic disparity between similarly situated bank-affiliated Qualified Intermediaries and independent Qualified Intermediaries. The smaller Qualified Intermediaries would be required to change their business practices, paying all income to the taxpayer and to charge higher fees to remain profitable, while large, bank-affiliated Qualified Intermediaries would generally be unaffected.

In response to the comments, the final regulations provide an exemption from section 7872 for exchange transactions in which the amount of exchange funds treated as loaned does not exceed $2 million and the funds are held for 6 months or less. The IRS advises that this exemption amount may be increased in future published guidance. Based upon comments received the $2 million amount is expected to exempt most deferred exchange transactions handled by small business exchange facilitators from the application of section 7872. This would eliminate a significant number of transactions which would generate only a nominal amount of tax revenue due to the small sums and short duration for which they are held. For sums over $2,000,000, the final regulations provide that, if exchange funds are held with a depository institution in an account (including a sub-account) that is separately identified with a taxpayer's name and Tax Identification Number, only the earnings on the account are treated as earnings attributable to the exchange funds. If the escrow agreement, trust agreement, or exchange agreement specifies that all the earnings attributable to exchange funds are payable to the taxpayer, the exchange funds are not treated as loaned from the taxpayer to the exchange facilitator. Thus taxpayer only takes into account all items of income, deduction, and credit attributable to the exchange funds. Even if the exchange facilitator commingles taxpayers' exchange funds (whether or not a taxpayer's funds are held in a separate account) all earnings attributable to a taxpayer's exchange funds are treated as paid to the taxpayer if all of the earnings allocable on a pro rata basis to a taxpayer, are paid to the taxpayer.

When an exchange facilitator benefits from the use of the taxpayer's exchange funds in a non-exempt account, characterizing the exchange funds as having been loaned from the taxpayer to the exchange facilitator is consistent with the substance of the transaction and with the definition of loan in the legislative history of Section 7872. It was felt that the standard AFR would produce too high an amount as the funds in an exchange are usually held short term. To mitigate the harshness of the standard AFR, the final regulations provide a special AFR that is the investment rate on a 13-week (generally, 91-day) Treasury bill. In addition, because the short-term AFR may be lower than the 91-day rate, the final regulations provide that taxpayers must apply the lower of the 91-day rate or the short-term AFR when testing for sufficient interest under Section 7872.

In order to allow for exchange companies to bring their forms and practices into compliance with the new regulations, the final regulations will only apply to transfers of relinquished property made on or after October 8, 2008. There is a transition rule with respect to transfers of relinquished property made by taxpayers after August 16, 1986, but before October 8, 2008. In those instances the Internal Revenue Service will not challenge "a reasonable, consistently applied method of taxation for income attributable to exchange funds."

Qualified Intermediaries such as Statewide Title Exchange Corporation will be largely unaffected by these amendments to the regulations because they have always segregated the taxpayers' accounts, identified them with the taxpayers' TIN, remitted all of the interest to, or on behalf of, the taxpayers and provided for the proper issuance of all required 1099's.