Each year we receive calls from taxpayers who have sold their investment property before engaging us to represent them as their Qualified Intermediary. They are still in possession of the cash and have just settled on Replacement Property to acquire and want our assistance in structuring the transaction to get the best tax deferred result. We listen patiently to their story and then advise them “it’s too late.” They have already triggered the tax by taking receipt of the funds and not having an agreement to exchange for the Relinquished Property before the sale.
Here is how this works from a practical standpoint: Seller, Bob, closes on investment property valued at $300,000.00 with a tax basis of $100,000.00 and the buyer pays cash at closing.
Bob conveys a deed at closing and the buyer accepts the deed, puts it on record and takes occupancy of the property. Bob then visits his bank to deposit the funds and makes an appointment to visit with his accountant to calculate the tax implications of the sale. After his visit with the accountant he is advised that he will be writing a check of $30,000 to the IRS and another check for state capital gains tax for $14,000 unless he exchanges the property and gets the deferral provided in Section 1031.
He is advised that his next call is to a Qualified Intermediary to get an Exchange Agreement. Wow, now he finds out “it’s too late” … unless, he can talk the buyer of his property into accepting the cash back and rescinding the deed conveyance. His buyer is wary of such an arrangement but is willing to do it if he can be compensated for his involvement. Bob is temporarily insulted, but knows that if he can’t get the cooperation of the buyer, he’ll have to pay the tax of $44,000.00.
After settling on an inconvenience fee of $5,000.00 and agreeing to pay all associated recording and legal costs the deed is unwound and the funds are restored to the seller. With both parties placed in the same positions as they were prior to the sale, they are in a position to start over. This time, Bob engages a QI to structure the sale as an Exchange and the parties agree on a date to conduct the sale again, this time as on exchange.
This strategy only works if the original sale and the rescission is done in the same tax year. It is also problematic if the buyer has purchased the property with the proceeds of financing. If that’s the case, the lender must also agree to cancel all of its paperwork and start over. You may be able to find a bank understanding enough to accommodate you but be prepared to pay them an inconvenience fee as well.
Guidance for this strategy can be found in Revenue Ruling 80-58. In part it states that “the legal concept of rescission refers to the abrogation, canceling, or voiding of a contract that has the effect of releasing the contracting parties from further obligations to each other and restoring the parties to the relative position that they would have occupied had no contract been made.”
It is always wiser to seek advice before the sale than to take your chances with the tax consequences. Take advice dating back to the 1st century B. C. of Publilius Syrus “Many receive advice, only the wise profit from it.”
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