What happens if my qualified intermediary goes bankrupt or steals my money?

The IRS starts from the fact that you cannot get at the money

Rev. Proc. 2010-14 opens with the practical reality rather than a theory of receipt: where the facilitator defaults and enters bankruptcy or receivership, the taxpayer 'generally may not seek to enforce its rights under the exchange agreement with the QI or otherwise access the sale proceeds from the relinquished property outside of the bankruptcy or receivership proceeding while the proceeding is pending.'

Its conclusion follows from that: 'the Service will treat the taxpayer as not having actual or constructive receipt of the proceeds during that period if the taxpayer reports gain in accordance with this revenue procedure.'

This does not extend your 45 or 180 days and does not save the exchange. It changes only when and how much of the gain is taxed, which in a multi-year bankruptcy is the difference between a tax bill on money you never touched and a tax bill on money you actually received.

Four scope tests, and the second one has a built-in escape

Section 3 of the revenue procedure is a gate, not a suggestion. Miss any of the four and the safe harbor is simply unavailable, and the ordinary rules on constructive receipt apply to the year of the sale.

• You transferred the relinquished property to the facilitator in accordance with Reg. §1.1031(k)-1(g)(4), which means the exchange agreement, assignment and notice were in place before the deed moved
• You properly identified replacement property within the identification period, unless the default occurred during that period
• The exchange failed solely because of the default, by a facilitator that becomes subject to bankruptcy under the United States Code or a receivership under federal or state law
• You did not have actual or constructive receipt of the sale proceeds or of any property of the facilitator before it entered bankruptcy or receivership, disregarding any debt relief that happened at your closing

The gross profit ratio decides how much of each distribution is taxed

The mechanism is borrowed from installment reporting. The taxable portion of any payment attributable to the relinquished property is the payment multiplied by gross profit over contract price, where gross profit is the selling price minus your adjusted basis, and contract price is the selling price minus any satisfied debt that did not exceed basis.

The selling price is normally the amount realized on the sale. It is reduced to what you will actually get if a court order, a confirmed plan or a written notice from the trustee fixes that number by the end of the first tax year in which you receive a payment.

Hypothetical with round numbers: an unencumbered property sells for $900,000 with a $300,000 adjusted basis, the facilitator fails, and a confirmed plan specifies $720,000 in full satisfaction, paid $360,000 in Year 2 and $360,000 in Year 3. Selling price and contract price are $720,000, gross profit is $420,000, the ratio is 420/720, and you report $210,000 of gain in each of Years 2 and 3 and nothing in Year 1.

A mortgage paid off at your closing can be taxable before any cash arrives

Debt satisfied at the relinquished closing is not treated as a payment, with one exception that catches highly leveraged sellers: the amount of satisfied debt in excess of your adjusted basis is treated as a payment in the year the debt was satisfied.

Hypothetical: the same sale carries a $500,000 mortgage paid off at closing and your adjusted basis is $400,000. The $100,000 excess is a deemed payment in the year of the sale, so gain is recognized that year even though the facilitator failed before you saw a dollar.

Two related rules travel with it. Depreciation recapture under sections 1245 and 1250 is picked up in the year gain is recognized, to the extent of the gain recognized that year, and total gain under the safe harbor cannot exceed your payments plus satisfied debt minus your adjusted basis, with any correction made in the final payment year.

When the recovery is less than your basis, section 165 does the work

Section 4.08 allows a loss deduction under section 165 for the amount by which your adjusted basis exceeds the sum of the payments attributable to the relinquished property, including satisfied debt above basis, plus satisfied debt not in excess of basis.

Hypothetical: the property sells for $900,000 with a $700,000 adjusted basis and no mortgage, and the trustee ultimately pays $600,000. There is no gain to report, and the $100,000 shortfall is a section 165 loss. If you had already recognized gain under the safe harbor in an earlier year, that amount is deductible too.

Timing follows the general section 165 rules and the character follows subchapter P, which is a way of saying your CPA decides the year and the character on your facts. Get that advice before filing rather than after, because the year a loss becomes fixed and determinable is the usual point of dispute.

One more timing rule is worth knowing: for imputed interest, you are treated as selling on the date the plan is confirmed or the court order resolves your claim, so a single payment made within six months of that date carries no imputed interest under section 483 or 1274.

The prevention is in the account structure, and the IRS says so

Section 6 of the same revenue procedure contains the most useful sentence in it for anyone whose money is still safe: 'existing regulations allow for the proceeds from the disposition of relinquished property to be held in such a way that they do not become property of a qualified intermediary's bankruptcy estate.'

That is the qualified escrow account and qualified trust of Reg. §1.1031(k)-1(g)(3), held by someone who is not you or a disqualified person, with an agreement that limits your access as (g)(6) requires. It is the alternative that Washington and California expressly allow their facilitators to use instead of posting a $1,000,000 fidelity bond.

Where a state statute applies, the protection is stated outright: exchange funds 'are not subject to execution or attachment on any claim against the exchange facilitator' under RCW 19.310.080(2) and Va. Code § 55.1-804(C). Choose on that basis before you wire; how do I choose a safe qualified intermediary turns it into a checklist, and protecting your exchange from wire fraud and QI mistakes covers the theft version.