Escrow Accounts, Trusts, and Other Funds Used During Deferred Exchanges of Like-Kind Property, 6231-6238 [06-1038]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 25 (Tuesday, February 7, 2006)]
[Proposed Rules]
[Pages 6231-6238]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-1038]


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Proposed Rules
                                                Federal Register
________________________________________________________________________

This section of the FEDERAL REGISTER contains notices to the public of 
the proposed issuance of rules and regulations. The purpose of these 
notices is to give interested persons an opportunity to participate in 
the rule making prior to the adoption of the final rules.

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Federal Register / Vol. 71, No. 25 / Tuesday, February 7, 2006 / 
Proposed Rules

[[Page 6231]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-113365-04 and REG-209619-93]
RIN 1545-BD19 and RIN 1545-AR82


Escrow Accounts, Trusts, and Other Funds Used During Deferred 
Exchanges of Like-Kind Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Partial withdrawal of notice of proposed rulemaking, notice of 
proposed rulemaking, and notice of public hearing.

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SUMMARY: This document withdraws in part a notice of proposed 
rulemaking under section 468B of the Internal Revenue Code (Code) 
relating to the taxation and reporting of income earned on qualified 
settlement funds and certain other funds, trusts, and escrow accounts. 
This document also contains proposed regulations under section 468B 
regarding the taxation of the income earned on escrow accounts, trusts, 
and other funds used during deferred exchanges of like-kind property, 
and proposed regulations under section 7872 regarding below-market 
loans to facilitators of these exchanges. The proposed regulations 
affect taxpayers that engage in deferred like-kind exchanges and escrow 
holders, trustees, qualified intermediaries, and others that hold funds 
during deferred like-kind exchanges. This document also provides notice 
of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by May 8, 2006. 
Outlines of topics to be discussed at the public hearing scheduled for 
June 6, 2006, at 10 a.m. must be received by May 16, 2006.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-113365-04), room 5203, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-113365-
04), courier's desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
electronic comments directly to the IRS Internet site at https://
www.irs.gov/regs or via the Federal eRulemaking Portal at https://
www.regulations.gov (IRS-REG-113365-04). The public hearing will be 
held in the auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations 
under section 468B, A. Katharine Jacob Kiss, (202) 622-4930; concerning 
the proposed regulations under section 7872, David Silber, (202) 622-
3930; concerning submission of comments, the hearing, and/or to be 
placed on the building access list to attend the hearing, Treena 
Garrett, (202) 622-3401 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document withdraws Sec.  1.468B-6 of a notice of proposed 
rulemaking (REG-209619-93) relating to the taxation of qualified 
settlement funds and certain other escrow accounts, trusts, and funds 
under section 468B(g) that was published in the Federal Register (64 FR 
4801) on February 1, 1999 (the 1999 proposed regulations). This 
document contains new proposed regulations that provide rules under 
sections 468B(g) and 7872 regarding the taxation of qualified escrow 
accounts, qualified trusts, and other escrow accounts, trusts, or funds 
used during section 1031 deferred exchanges of like-kind property.
    Section 468B was added by section 1807(a)(7)(A) of the Tax Reform 
Act of 1986 (Pub. L. 99-514, 100 Stat. 2814) and was amended by section 
1018(f) of the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. 
100-647, 102 Stat. 3582). Section 468B(g) provides that nothing in any 
provision of law shall be construed as providing that an escrow 
account, settlement fund, or similar fund is not subject to current 
income tax and that the Secretary shall prescribe regulations providing 
for the taxation of such accounts or funds whether as a grantor trust 
or otherwise.
    Section 7872 was added to the Internal Revenue Code by the Tax 
Reform Act of 1984 (Pub. L. 98-369, 98 Stat. 494). Section 7872 
provides rules for certain direct and indirect below-market loans 
enumerated in section 7872(c)(1). The legislative history of section 
7872 states that the term loan is to be interpreted broadly for 
purposes of section 7872, potentially encompassing any transfer of 
money that provides the transferor with a right to repayment. See H.R. 
Rep. 98-861, 98th Cong., 2d Sess. 1018 (1984).
    In general, section 7872 recharacterizes a below-market loan (a 
loan in which the interest rate charged is less than the applicable 
Federal rate (AFR)) as an arm's-length transaction in which the lender 
makes a loan to the borrower at the AFR, coupled with an imputed 
payment or payments to the borrower sufficient to fund all or part of 
the interest that the borrower is treated as paying on that loan. The 
amount, timing, and characterization of the imputed payments to the 
borrower under a below-market loan depend on the relationship between 
the borrower and the lender and whether the loan is characterized as a 
demand loan or a term loan.
    Written comments responding to the 1999 proposed regulations under 
section 468B were received. A public hearing was held on May 12, 1999. 
After consideration of all the comments, portions of the 1999 proposed 
regulations are adopted in a Treasury decision published elsewhere in 
this issue of the Federal Register. The rules relating to the taxation 
of qualified escrow accounts, qualified trusts, and other escrow 
accounts, trusts, or funds used during deferred exchanges of like-kind 
property under section 1031 have been substantially revised and are 
reproposed in this notice of proposed rulemaking. All comments received 
in connection with the 1999 proposed regulations will continue to be 
considered in finalizing these proposed regulations.

Explanation of Provisions and Summary of Comments

1. Overview

    Section 1.468B-6 of the 1999 proposed regulations provides rules 
for the current taxation of income of a qualified escrow account or 
qualified trust used in a section 1031 deferred

[[Page 6232]]

exchange of like-kind property. The 1999 proposed regulations provide 
that, in general, the taxpayer (the transferor of the property) is the 
owner of the assets in a qualified escrow account or qualified trust 
and must take into account all items of income, deduction, and credit 
(including capital gains and losses) of the qualified escrow account or 
qualified trust. However, if, under the facts and circumstances, a 
qualified intermediary or transferee has the beneficial use and 
enjoyment of the assets, then the qualified intermediary or transferee 
is the owner of the assets in the qualified escrow account or qualified 
trust and must take into account all items of income, deduction, and 
credit (including capital gains and losses) of the qualified escrow 
account or qualified trust. The 1999 proposed regulations further 
provide that, if a qualified intermediary or transferee is the owner of 
the assets transferred, the transaction may be characterized as a 
below-market loan from the taxpayer to the owner to which section 7872 
may apply.
    The comments received reflect differing interpretations of the 1999 
proposed regulations and disagreement on the proper rules for taxing 
these transactions. The comments address three major issues (1) whether 
Sec.  1.468B-6 should apply to all funds and accounts maintained by 
qualified intermediaries to facilitate deferred like-kind exchanges as 
well as to qualified escrow accounts and qualified trusts (the scope of 
the rules); (2) whether the regulations should adopt a per se rule in 
place of the facts and circumstances ownership test; and (3) whether 
these arrangements may be properly characterized as loans. Other 
comments requested clarification of the information reporting 
provisions.

2. Scope of the Rule

    Section 1.1031(k)-1(g) of the Income Tax Regulations provides safe 
harbors that allow taxpayers to engage in deferred exchanges of like-
kind property and to avoid being determined to be in actual or 
constructive receipt of the proceeds from the sale of the taxpayers' 
relinquished property during the exchange period. The proceeds may be 
held in a qualified escrow account or qualified trust or may be held by 
a qualified intermediary. The 1999 proposed regulations address the 
treatment of only qualified escrow accounts and qualified trusts 
whether or not used by a qualified intermediary, and do not address 
accounts or funds used by a qualified intermediary that are not 
qualified escrow accounts or qualified trusts.
    Commentators on the 1999 proposed regulations stated that qualified 
intermediaries may maintain funds in accounts that are not qualified 
escrow accounts or qualified trusts, including accounts in which the 
proceeds of a disposition of relinquished property are commingled with 
other assets, such as the proceeds from deferred like-kind exchanges 
entered into by other taxpayers. Some commentators recommended applying 
the rules of Sec.  1.468B-6 to income earned on amounts held in any 
escrow account, trust, or other account or fund used by a qualified 
intermediary in connection with a deferred like-kind exchange. They 
suggested that the limited scope of the 1999 proposed regulations may 
result in uncertainty and inconsistent treatment of the different types 
of accounts that may be used for similar purposes in deferred like-kind 
exchanges.
    Other commentators took the contrary position, that is, that 
applying the rules proposed in 1999 to accounts other than qualified 
escrow accounts or qualified trusts is inappropriate. One commentator 
stated that at least one party (either the taxpayer or the qualified 
intermediary) is taxed on the income earned on every account used by a 
qualified intermediary. Therefore, the commentator reasoned, because 
there are no instances of homeless income (income that is not currently 
being taxed because the identity of the taxpayer has yet to be 
determined), applying the proposed regulations to escrow accounts or 
funds that are not qualified escrow accounts or qualified trusts would 
not advance the purpose of the statute. Another commentator opined that 
section 468B was intended to apply only to segregated accounts.
    Other commentators urged that the 1999 proposed regulations be 
finalized without change or that the appropriate rules for taxation of 
accounts used in deferred like-kind exchanges other than qualified 
escrow accounts and qualified trusts should be considered at a later 
time.
    The IRS and the Treasury Department have concluded that the same 
rules should apply to all escrow accounts, trusts, and funds used 
during deferred exchanges to provide certainty and consistency of 
treatment. Additionally, the IRS and the Treasury Department have 
concluded that the rules should apply equally to escrow accounts, 
trusts, and funds used during exchanges that are intended to qualify as 
like-kind but fail to satisfy a requirement of section 1031. Therefore, 
these regulations propose to apply to exchange funds, defined as the 
relinquished property (if held in kind), cash, or cash equivalent that 
secures an obligation of a transferee to transfer replacement property, 
or the proceeds from a transfer of relinquished property, held in a 
qualified escrow account, qualified trust, or other escrow account, 
trust, or fund during a deferred exchange.

3. Facts and Circumstances Ownership Test

    Under the 1999 proposed regulations, the taxpayer generally is 
treated as the owner of a qualified escrow account or qualified trust 
and is taxed on the income. If, under the facts and circumstances, 
however, a qualified intermediary or transferee has the beneficial use 
and enjoyment of the assets in the account, the qualified intermediary 
or transferee is the owner and is taxed on the income. The 1999 
proposed regulations provide three factors that will be considered in 
addition to other relevant facts and circumstances in determining 
whether the transferee or qualified intermediary, rather than the 
taxpayer, has the beneficial use and enjoyment of the assets of the 
account or trust (1) who enjoys the use of the earnings of the account 
or trust; (2) who receives the benefit from appreciation in the value 
of the assets; and (3) who bears any risk of loss from a decline in the 
value of the assets. The 1999 proposed regulations include two examples 
that conclude that the taxpayer is the owner of the assets if the 
income from a qualified escrow account or qualified trust is paid to 
the qualified intermediary or transferee as compensation for services 
performed for the taxpayer. See Old Colony Trust v. Commissioner, 279 
U.S. 716 (1929).
    Some commentators recommended that the facts and circumstances test 
be eliminated and that the regulations provide a per se rule that the 
taxpayer must always take into account all items of income, deduction, 
and credit (including capital gains and losses) of the exchange funds 
in computing the taxpayer's income tax liability. They suggested that 
the taxpayer always owns the exchange funds and any income earned on 
the funds that is retained by the qualified intermediary constitutes 
compensation to the qualified intermediary for services rendered to the 
taxpayer in facilitating the deferred like-kind exchange. Therefore, 
consistent with the principles of Old Colony Trust, the taxpayer should 
be taxed on all the earnings in all cases.
    Other commentators urged that the facts and circumstances test 
should be retained. They stated that like-kind exchanges are often 
structured so that a

[[Page 6233]]

qualified intermediary has all the benefits and burdens of ownership of 
the exchange funds and that, in those circumstances, a qualified 
intermediary is the owner of the assets under general tax principles. 
These commentators explained that qualified intermediaries frequently 
charge separately stated fees that are the same if the earnings are 
paid to the taxpayer or retained by the qualified intermediary, 
indicating, they asserted, that the qualified intermediary's retention 
of the income is not properly characterized as compensation for 
services. These commentators further suggested, therefore, that in 
appropriate cases the qualified intermediary is the actual owner of the 
assets and the Old Colony Trust doctrine is inapplicable. These 
commentators also recommended that the rules should be sufficiently 
broad to permit parties to deferred like-kind exchanges flexibility in 
structuring the transactions, for example in the disposition of the 
income earned and in the use of commingled rather than segregated 
accounts.
    A commentator recommended modifying the ownership rule to allow the 
allocation of the tax liability among the parties to the exchange and 
the qualified intermediary to the extent that those parties actually 
share the income earned on a qualified escrow account or qualified 
trust.
    To enhance administrability, provide greater certainty, and ensure 
consistent treatment of taxpayers, these proposed regulations eliminate 
the facts and circumstances ownership test and propose specific rules 
that determine whether the income of an escrow account, trust, or fund 
used in a deferred like-kind exchange is taxed to the taxpayer or to an 
exchange facilitator, which is a qualified intermediary, transferee, or 
other party that holds the exchange funds. These rules are discussed 
further below.
    Because the ownership test has been eliminated, these proposed 
regulations also eliminate the requirement in the 1999 proposed 
regulations that the parties provide a statement to the escrow holder 
or trustee when the taxpayer is not the owner of the assets.

4. Loan Treatment

    One commentator argued that the treatment of a qualified 
intermediary as acquiring the relinquished property under the section 
1031 regulations applies solely for purposes of section 1031. This 
commentator suggested that proceeds from the sale of the relinquished 
property in a deferred exchange are properly characterized in one of 
only two ways: (1) The taxpayer owns the funds and is taxed on the 
earnings; or (2) under section 7872, the taxpayer is treated as lending 
the funds to the qualified intermediary, in which case the qualified 
intermediary (or exchange facilitator) owns the funds and is treated as 
paying interest on the loan. The commentator also urged that, for 
reasons of administrative convenience, the parties should be permitted 
to elect either characterization and the rules should apply 
prospectively.
    Other commentators stated that, if a qualified intermediary has the 
benefits and burdens of ownership, the funds are owned by the qualified 
intermediary and not the taxpayer, and therefore could not be loaned by 
the taxpayer. Because the taxpayer is deemed not to have actual or 
constructive receipt of the exchange funds under the rules of Sec.  
1.1031(k)-1, these commentators reasoned that a taxpayer cannot lend 
assets it does not possess.
    The IRS and the Treasury Department agree with the comment that 
exchange funds held by exchange facilitators in connection with 
deferred like-kind exchanges are properly characterized either as the 
taxpayer's funds or as loans from the taxpayer to the qualified 
intermediary or other exchange facilitator. Characterizing the exchange 
funds as having been loaned is consistent with the broad definition of 
the term loan in the legislative history of section 7872. The 
provisions of Sec.  1.1031(k)-1, stating that the taxpayer is deemed to 
not have actual or constructive receipt of the exchange funds if the 
safe harbors apply, do not preclude loan treatment. These rules permit 
taxpayers to engage in like-kind exchanges on a deferred basis but are 
not statements of general tax principles. See Sec.  1.1031-1(n).
    Therefore, these proposed regulations provide that exchange funds 
are treated, as a general rule, as loaned by a taxpayer to an exchange 
facilitator, and the exchange facilitator takes into account all items 
of income, deduction, and credit (including capital gains and losses). 
If, however, 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, and the 
taxpayer takes into account all items of income, deduction, and credit 
(including capital gains and losses). If an exchange facilitator 
commingles exchange funds with other funds (for example, for investment 
purposes), all the earnings attributable to the exchange funds are 
treated as paid to the taxpayer if the exchange facilitator pays the 
taxpayer all the earnings of the commingled account that are allocable 
on a pro-rata basis (using a reasonable method that takes into account 
the time that the exchange funds are in the commingled account, actual 
rate or rates of return, and the respective principal balances) to the 
taxpayer's exchange funds.
    Payments from the exchange funds, or from the earnings attributable 
to the exchange funds, for the taxpayer's transactional expenses are 
treated as first paid to the taxpayer and then paid by the taxpayer to 
the recipient. Transactional expenses include the costs of land 
surveys, appraisals, title examinations, termite inspections, transfer 
taxes, and recording fees. An exchange facilitator's fee is a 
transactional expense only if the escrow agreement, trust agreement, or 
exchange agreement, as applicable, provides that (1) the amount of the 
fee payable to the exchange facilitator is fixed on or before the date 
of the transfer of the relinquished property by the taxpayer (either by 
stating the fee as a fixed dollar amount in the agreement or 
determining the fee by a formula, the result of which is known on or 
before the transfer of the relinquished property by the taxpayer), and 
(2) the amount of the fee is payable by the taxpayer regardless of 
whether the earnings attributable to the exchange funds are sufficient 
to pay the fee.

5. Treatment Under Section 7872 of Loans to Exchange Facilitators

    The 1999 proposed regulations provide that if a qualified 
intermediary or transferee is the owner of the assets transferred, 
section 7872 may apply ``if the deferred exchange involves a below-
market loan from the taxpayer to the owner.''
    Several commentators did not agree that section 7872 could apply to 
exchange funds and suggested that the reference should be deleted. 
Commentators also suggested that, even if a transfer of the exchange 
funds from the taxpayer to an exchange facilitator is a loan, it would 
constitute a loan given in consideration for the sale or exchange of 
property (within the meaning of section 1274(c)(1)) or a deferred 
payment on account of a sale or exchange of property (within the 
meaning of section 483) and would be exempt from section 7872 under the 
rules contained in Sec. 1.7872-2(a)(2)(ii) of the proposed regulations 
that were published in the Federal Register (50 FR 33553) on August 20, 
1985 (the 1985 proposed regulations). These commentators further argued 
that exchange facilitator loans should be exempted from section 7872 
because

[[Page 6234]]

those loans must be repaid within six months. These commentators argued 
that the section 1274 exclusion of debt instruments payable within six 
months evidences Congress' intent that burdensome reporting and 
recordkeeping requirements should not apply to short-term loans.
    Having considered the comments received, the IRS and the Treasury 
Department conclude that section 7872, rather than sections 1274 or 
483, applies to loans from taxpayers to exchange facilitators. 
Therefore, these proposed regulations provide special rules under 
section 7872 for the treatment of exchange facilitator loans. Under 
these proposed regulations, an exchange facilitator loan is a 
transaction that, under Sec. 1.468B-6(c)(1), is treated as a loan from 
the taxpayer to an exchange facilitator in connection with a section 
1031 deferred exchange. Below-market exchange facilitator loans are 
treated as compensation-related loans under section 7872(c)(1)(B) and 
are treated as demand loans for purposes of section 7872.
    A commentator suggested that, if section 7872 applies to these 
transactions, interest should be tested and imputed at an alternative 
rate (similar to the alternative rate in Sec.  1.1274-4(a)(iii)) rather 
than at the short-term AFR. These proposed regulations provide an 
alternative rate (the 182-day rate) for exchange facilitator loans for 
purposes of section 7872. This rate is equal to the investment rate on 
a 182-day Treasury bill determined on the auction date that most 
closely precedes the date that the exchange facilitator loan is made. 
This rate is based on semi-annual compounding and may be found at 
https://wwws.publicdebt.treas.gov/AI/OFBills. The IRS and the Treasury 
Department request comments regarding alternative rates for exchange 
facilitator loans under section 7872, including whether the 182-day 
Treasury bill rate is an appropriate rate. Notwithstanding Sec. 1.7872-
13 of the 1985 proposed regulations, the taxpayer and exchange 
facilitator may use the approximate method to determine the amount of 
forgone interest on an exchange facilitator loan.
    One commentator urged that a de minimis exception for loans of 
exchange funds under $10,000,000 should be added under Sec. 1.7872-5T 
because these loans are without significant tax effect. Several other 
commentators opined that Sec. 1.7872-5T(b)(14) should exempt loans of 
exchange funds from section 7872 because they are loans without 
significant tax effect. However, the proposed regulations provide that 
exchange facilitator loans are not eligible for the exemptions listed 
in Sec. 1.7872-5T(b), including Sec. 1.7872-5T(b)(14). An exchange 
facilitator loan may be excepted from the application of section 7872 
only if the loan qualifies for the $10,000 de minimis exception in 
section 7872(c)(3) for compensation-related loans.

6. Information Reporting

    The 1999 proposed regulations state that an escrow holder or 
trustee must report the income of the escrow, trust, or fund on Form 
1099 in accordance with subpart B, Part III, subchapter A, chapter 61, 
Subtitle F of the Code (currently, sections 6041 through 6050T), and 
provide rules for identifying the payee. Several commentators expressed 
concern that these provisions expand the existing information reporting 
obligations in sections 6041 through 6050T. The 1999 proposed 
regulations were not intended to create new information reporting 
requirements but merely to alert responsible persons of the potential 
obligation to report. To clarify this intent, these proposed 
regulations provide that a payor must report to the extent required by 
sections 6041 through 6050T and these regulations.
    To enhance compliance, a commentator recommended that payors should 
be required to furnish Forms 1099 to corporate payees involved in 
deferred like-kind exchanges. This suggestion was not adopted because 
it would be inconsistent with provisions of sections 6041 through 6050T 
and the regulations thereunder that exempt payments to corporations 
from the information reporting requirements.

7. Effective Dates

    Sections 1.468B-6 and 1.7872-16 apply, respectively, to transfers 
of property made by taxpayers and to exchange facilitator loans issued 
after the date these regulations are published as final regulations in 
the Federal Register. Section 1.468B-6 of these proposed regulations 
incorporates a transition rule similar to the transition rule in the 
1999 proposed regulations. The transition rule provides that, with 
respect to transfers of property made by taxpayers after August 16, 
1986, but on or before the date these regulations are published as 
final regulations in the Federal Register, the IRS will not challenge a 
reasonable, consistently applied method of taxation for income 
attributable to exchange funds.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. An initial 
regulatory flexibility analysis has been prepared for this notice of 
proposed rulemaking under 5 U.S.C. 603. The analysis is set forth below 
under the heading ``Initial Regulatory Flexibility Analysis.'' Pursuant 
to section 7805(f) of the Code, this notice of proposed rulemaking will 
be submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small businesses.

Initial Regulatory Flexibility Analysis

    The reasons for promulgation of these rules, and their legal basis, 
are set forth in this preamble under the heading ``Background.''
    These rules impact exchange facilitators that hold exchange funds 
for taxpayers engaging in deferred exchanges of like-kind property. 
Exchange facilitators may be individuals, large entities such as banks, 
or small businesses. The IRS and the Treasury Department estimate that 
nationwide there are approximately 325 small businesses providing 
services as exchange facilitators, primarily as qualified 
intermediaries. For this purpose, a small business is defined as a 
business with annual receipts of up to $1.5 million, as provided in the 
Small Business Administration size standards set forth at 13 CFR 
121.201 for NAICS code 531390 (other activities related to real 
estate).
    Section 1.468B-6(c)(2) provides that exchange funds are not treated 
as loaned to an exchange facilitator if all the earnings attributable 
to the exchange funds are paid to a taxpayer. If the exchange 
facilitator commingles the exchange funds, the exchange facilitator 
will be required to account for the earnings attributable to the 
taxpayer's exchange funds.
    As an alternative to these rules, retaining the facts and 
circumstances test of the 1999 proposed regulations was considered but 
rejected because the test lacks administrability and is subject to 
abuse. Other alternatives were considered and rejected as inconsistent 
with the statutory requirements of section 7872.
    The number of transactions involving small entities that will be 
impacted by these regulations, and the full extent of the economic 
impact, cannot be precisely determined. Exchange facilitators may 
simplify the accounting for the earnings attributable to each 
taxpayer's exchange funds held in a commingled account by depositing 
each taxpayer's exchange funds in a

[[Page 6235]]

segregated account and paying the taxpayer all the earnings of that 
account.
    Comments are requested on the nature and extent of the economic 
burden imposed on small entities by these rules and on alternatives 
that would be less burdensome to small entities.
    The IRS and the Treasury Department are not aware of any 
duplicative, overlapping, or conflicting Federal rules.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The IRS and the Treasury Department specifically request comments 
on the clarity of the proposed regulations and how they may be made 
easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for June 6, 2006, at 10 a.m., 
in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC. Due to building security procedures, visitors must 
enter at the Constitution Avenue entrance. In addition, all visitors 
must present photo identification to enter the building. Because of 
access restrictions, visitors will not be admitted beyond the immediate 
entrance more than 30 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of topics to be discussed and the time 
devoted to each topic (signed original and eight (8) copies) by May 16, 
2006. A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are A. Katharine Jacob 
Kiss of the Office of Associate Chief Counsel (Income Tax & Accounting) 
and Rebecca Asta of the Office of Associate Chief Counsel (Financial 
Institutions & Products). However, other personnel from the IRS and the 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of Proposed Amendments to the Regulations

    Accordingly, under the authority of 26 U.S.C. 7805, Sec. Sec.  
1.468B-6 and 1.1031(k)-1(g)(3)(i) and (h)(2) of a notice of proposed 
rulemaking (REG-209619-93) amending 26 CFR part 1 that was published in 
the Federal Register (64 FR 4801) on February 1, 1999, are withdrawn.

Proposed Amendments to the Regulations

    Accordingly, under the authority of 26 U.S.C. 7805, 26 CFR part 1 
is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.468B-6 also issued under 26 U.S.C. 468B(g). * * *
    Section 1.7872-16 also issued under 26 U.S.C. 7872. * * *
    Par. 2. Section 1.468B-0 is amended by revising the entries for 
Sec. 1.468B-6 to read as follows:


Sec.  1.468B-0  Table of contents.

* * * * *


Sec.  1.468B-6  Escrow accounts, trusts, and other funds used during 
deferred exchanges of like-kind property under section 1031(a)(3).

    (a) Scope.
    (b) Definitions.
    (1) In general.
    (2) Exchange funds.
    (3) Exchange facilitator.
    (4) Transactional expenses.
    (i) In general.
    (ii) Special rule for certain fees for exchange facilitator 
services.
    (c) Taxation of exchange funds.
    (1) Exchange funds generally treated as loaned to an exchange 
facilitator.
    (2) Exchange funds not treated as loaned to an exchange 
facilitator.
    (i) Scope.
    (ii) Treatment of the taxpayer.
    (d) Information reporting requirements.
    (e) Examples.
    (f) Effective dates.
    (1) In general.
    (2) Transition rule.
* * * * *
    Par. 3. Section 1.468B-6 is added to read as follows:


Sec.  1.468B-6  Escrow accounts, trusts, and other funds used during 
deferred exchanges of like-kind property under section 1031(a)(3).

    (a) Scope. This section provides rules under section 468B(g) 
relating to the current taxation of escrow accounts, trusts, and other 
funds used during deferred exchanges.
    (b) Definitions. The definitions in this paragraph (b) apply for 
purposes of this section.
    (1) In general. Deferred exchange, escrow agreement, escrow holder, 
exchange agreement, exchange period, qualified escrow account, 
qualified intermediary, qualified trust, relinquished property, 
replacement property, taxpayer, trust agreement, and trustee have the 
same meanings as in Sec. 1.1031(k)-1; deferred exchange also includes 
any exchange intended to qualify as a deferred exchange, and qualified 
intermediary also includes any person or entity intended by a taxpayer 
to be a qualified intermediary within the meaning of Sec.  1.1031(k)-
1(g)(4).
    (2) Exchange funds. Exchange funds means relinquished property, 
cash, or cash equivalent, that secures an obligation of a transferee to 
transfer replacement property, or proceeds from a transfer of 
relinquished property, held in a qualified escrow account, qualified 
trust, or other escrow account, trust, or fund during an exchange 
period.
    (3) Exchange facilitator. Exchange facilitator means a qualified 
intermediary, transferee, escrow holder, trustee, or other party that 
holds exchange funds for a taxpayer during an exchange period.
    (4) Transactional expenses--(i) In general. Transactional expenses 
means the usual and customary expenses paid or incurred in connection 
with a deferred exchange. For example, the costs of land surveys, 
appraisals, title examinations, termite inspections, transfer taxes, 
and recording fees are transactional expenses. Except as provided in 
paragraph (b)(4)(ii) of this section, the fee for the services of an 
exchange facilitator is not treated as a transactional expense.
    (ii) Special rule for certain fees for exchange facilitator 
services. The fee for the services of an exchange facilitator will be 
treated as a transactional expense if the escrow agreement, trust 
agreement, or exchange agreement, as applicable, provides that--
    (A) The amount of the fee payable to the exchange facilitator is 
fixed on or before the date of the transfer of the relinquished 
property by the taxpayer (either by stating the fee as a fixed dollar 
amount in the agreement or determining the fee by a formula, the result 
of which

[[Page 6236]]

is known on or before the transfer of the relinquished property by the 
taxpayer); and
    (B) The amount of the fee is payable by the taxpayer regardless of 
whether the earnings attributable to the exchange funds are sufficient 
to pay the fee.
    (c) Taxation of exchange funds--(1) Exchange funds generally 
treated as loaned to an exchange facilitator. Except as provided in 
paragraph (c)(2) of this section, exchange funds are treated as loaned 
from a taxpayer to an exchange facilitator. The exchange facilitator 
must take into account all items of income, deduction, and credit 
(including capital gains and losses) attributable to the exchange 
funds. See Sec.  1.7872-16 to determine if a loan from a taxpayer to an 
exchange facilitator is a below-market loan for purposes of section 
7872.
    (2) Exchange funds not treated as loaned to an exchange 
facilitator--(i) Scope. This paragraph (c)(2) applies if, in accordance 
with an escrow agreement, trust agreement, or exchange agreement, as 
applicable, all the earnings attributable to a taxpayer's exchange 
funds are paid to the taxpayer. For purposes of this paragraph (c)(2)--
    (A) Any payment from the taxpayer's exchange funds, or from the 
earnings attributable to the taxpayer's exchange funds, for a 
transactional expense of the taxpayer (as defined in paragraph (b)(4) 
of this section) is treated as first paid to the taxpayer and then paid 
by the taxpayer to the recipient; and
    (B) If an exchange facilitator commingles (for investment or 
otherwise) the taxpayer's exchange funds with other funds or assets 
(whether or not the taxpayer's funds are in a segregated account), all 
the earnings attributable to the taxpayer's exchange funds are paid to 
the taxpayer if all of the earnings of the commingled funds or assets 
that are allocable on a pro-rata basis (using a reasonable method that 
takes into account the time that the exchange funds are in the 
commingled account, actual rate or rates of return, and the respective 
account balances) to the taxpayer's exchange funds either are paid to 
the taxpayer or are treated as paid to the taxpayer under paragraph 
(c)(2)(i)(A) of this section.
    (ii) Treatment of the taxpayer. If this paragraph (c)(2) applies, 
exchange funds are not treated as loaned from a taxpayer to an exchange 
facilitator. The taxpayer must take into account all items of income, 
deduction, and credit (including capital gains and losses) attributable 
to the exchange funds.
    (d) Information reporting requirements. A payor (as defined in 
Sec.  1.6041-1) must report the income attributable to exchange funds 
on Form 1099 to the extent required by the information reporting 
provisions of subpart B, Part III, subchapter A, chapter 61, Subtitle F 
of the Internal Revenue Code, and the regulations thereunder. See Sec.  
1.6041-1(f) for rules relating to the amount to be reported when fees, 
expenses or commissions owed by a payee to a third party are deducted 
from a payment.
    (e) Examples. The provisions of this section are illustrated by the 
following examples in which T is a taxpayer that uses a calendar 
taxable year and the cash receipts and disbursements method of 
accounting. The examples are as follows:

    Example 1. All earnings attributable to exchange funds paid to 
taxpayer. (i) T enters into a deferred exchange with R. The sales 
agreement provides that T will transfer property (the relinquished 
property) to R and R will transfer replacement property to T. R's 
obligation to transfer replacement property to T is secured by cash 
equal to the fair market value of the relinquished property that R 
will deposit into a qualified escrow account that T establishes with 
B, a financial institution. T enters into an escrow agreement with B 
that provides that all the earnings attributable to the exchange 
funds will be paid to T.
    (ii) On February 1, 2006, T transfers property with a fair 
market value of $100,000 to R and R deposits $100,000 in T's 
qualified escrow account with B. Between February 1 and June 1, 
2006, T's exchange funds earn $750. On June 1, 2006, R transfers 
replacement property worth $100,000 to T and B pays $100,000 from 
the qualified escrow account to R. Additionally, on June 1, B 
credits the qualified escrow account with $750 of earnings and pays 
the earnings to T.
    (iii) Under paragraph (b) of this section, the $100,000 
deposited with B are exchange funds and B is an exchange 
facilitator. Because all the earnings attributable to the exchange 
funds are paid to T in accordance with the escrow agreement, 
paragraph (c)(2) of this section applies. The exchange funds are not 
treated as loaned from T to B, and T must take into account in 
computing T's income tax liability for 2006 the $750 of earnings 
credited to the qualified escrow account.
    Example 2. Payment of transactional expenses from earnings. (i) 
The facts are the same as in Example 1, except that the escrow 
agreement provides that, prior to paying the earnings to T, B may 
deduct any amounts B has paid to third parties for T's transactional 
expenses. B pays a third party $350 on behalf of T for a survey of 
the replacement property. After deducting $350 from the earnings 
attributable to T's qualified escrow account, B pays T the remainder 
($400) of the earnings.
    (ii) Under paragraph (b)(4) of this section, the cost of the 
survey is a transactional expense. Under paragraph (c)(2)(i)(A) of 
this section, the $350 that B pays for the survey is treated as 
first paid to T and then from T to the third party. Therefore, all 
the earnings attributable to T's exchange funds are paid or treated 
as paid to T in accordance with the escrow agreement, and paragraph 
(c)(2) of this section applies. The exchange funds are not treated 
as loaned from T to B, and T must take into account in computing T's 
income tax liability for 2006 the $750 of earnings credited to the 
qualified escrow account.
    Example 3. Earnings retained by exchange facilitator as 
compensation for services. (i) The facts are the same as in Example 
1, except that the escrow agreement provides that B also may deduct 
any outstanding fees owed by T for B's services in facilitating the 
deferred exchange. In accordance with paragraph (b)(4)(ii) of this 
section, the escrow agreement provides for a fixed fee of $200 for 
B's services, which is payable by T regardless of the amount of 
earnings attributable to the exchange funds. Because the earnings on 
the exchange funds in this case exceed $200, B retains $200 as the 
unpaid portion of its fee and pays T the remainder ($550) of the 
earnings.
    (ii) Under paragraph (b)(4) of this section, B's fee is treated 
as a transactional expense. Under paragraph (c)(2)(i)(A) of this 
section, the $200 that B retains for its fee is treated as first 
paid to T and then from T to B. Therefore, all the earnings 
attributable to T's exchange funds are paid or treated as paid to T 
in accordance with the escrow agreement, and paragraph (c)(2) of 
this section applies. The exchange funds are not treated as loaned 
from T to B, and T must take into account in computing T's income 
tax liability for 2006 the $750 of earnings credited to the 
qualified escrow account.
    Example 4. Stated rate of interest on account less than earnings 
attributable to exchange funds. (i) The facts are the same as in 
Example 1, except that the escrow agreement provides that the 
qualified escrow account will earn a stated rate of interest. B 
invests the exchange funds and earns $750, but credits $500 to the 
qualified escrow account at the stated rate. B pays to T the $500 of 
interest earned at the stated rate on the qualified escrow account.
    (ii) Paragraph (c)(1) of this section applies and the exchange 
funds are treated as loaned from T to B. B must take into account in 
computing B's income tax liability all items of income, deduction, 
and credit (including capital gains and losses) attributable to the 
exchange funds. Paragraph (c)(2) of this section does not apply 
because B does not pay all the earnings attributable to the exchange 
funds to T. See Sec.  1.7872-16 for rules relating to exchange 
facilitator loans.
    Example 5. Exchange funds deposited by exchange facilitator with 
financial institution in account in taxpayer's name. (i) The facts 
are the same as in Example 1, except that, instead of entering into 
an escrow agreement, T enters into an exchange agreement with QI, a 
qualified intermediary. The exchange agreement provides that R will 
pay $100,000 to QI, QI will deposit $100,000 into an account with a 
financial institution under T's name and taxpayer identification 
number (TIN), and all the earnings attributable to the account will 
be paid to T.
    (ii) On February 1, 2006, T transfers property with a fair 
market value of $100,000 to R, R delivers $100,000 to QI, and QI

[[Page 6237]]

deposits $100,000 into a money market account with B, a financial 
institution unrelated to QI, under T's name and TIN. Between 
February 1 and June 1, 2006, the account earns $500 of interest at 
the stated rate established by B. On June 1, 2006, QI uses $100,000 
of the funds in the account to purchase replacement property 
identified by T and transfers the replacement property to T. B pays 
to T the $500 of interest earned on the money market account.
    (iii) Under paragraph (b) of this section, the $100,000 QI 
receives from R for the relinquished property are exchange funds and 
QI is an exchange facilitator. B is not an exchange facilitator. T 
has no direct relationship with B, and QI, not B, holds the exchange 
funds on behalf of T. Because all the earnings attributable to the 
exchange funds held by QI are paid to T in accordance with the 
exchange agreement, paragraph (c)(2) of this section applies. The 
exchange funds are not treated as loaned from T to QI, and T must 
take into account in computing T's income tax liability for 2006 the 
$500 of interest earned on the money market account.
    Example 6. All earnings attributable to commingled exchange 
funds paid to taxpayer. (i) The facts are the same as in Example 5, 
except that the exchange agreement does not specify how the $100,000 
QI receives from R must be invested.
    (ii) On February 1, 2006, QI deposits the $100,000 with B, a 
financial institution, in a pre-existing interest-bearing account 
under QI's name and TIN. The account has a total balance of $275,000 
immediately thereafter. On the last day of each month between 
February and June, 2006, the account earns interest as follows: $690 
in February, $920 in March, $516 in April, and $986 in May. On April 
11, 2006, QI deposits $50,000 in the account. On May 15, 2006, QI 
withdraws $175,000 from the account.
    (iii) QI calculates T's pro-rata share of the earnings allocable 
to the $100,000 based on the actual return, the average daily 
principal balances, and a 30-day month convention, as follows:

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             Account's avg.     T's avg. daily                       Monthly interest
                          Month                                daily bal.            bal.           T's share *         (percent)       T's end. bal.**
--------------------------------------------------------------------------------------------------------------------------------------------------------
February.................................................           $275,000           $100,000               36.4               $690           $100,251
March....................................................            275,690            100,251               36.4                920            100,586
April....................................................            309,943            100,586               32.5                516            100,754
May......................................................            236,626            100,754               42.6                986            101,174
--------------------------------------------------------------------------------------------------------------------------------------------------------
* T's Average Daily Balance / Account's Average Daily Balance.
** T's beginning balance + [(T's share)(Monthly Interest)].

    (iv) On June 1, 2006, QI uses $100,000 of the funds to purchase 
replacement property identified by T and transfers the property to 
T. QI pays $1,174, the earnings of the account allocated to T's 
exchange funds, to T.
    (v) Under paragraph (b) of this section, the $100,000 from the 
sale of the relinquished property are exchange funds and QI is an 
exchange facilitator. Because QI uses a reasonable method to 
calculate the pro-rata share of account earnings allocable to T's 
exchange funds and pays all those earnings to T, paragraph (c)(2) of 
this section applies. The exchange funds are not treated as loaned 
from T to QI. T must take into account in computing T's income tax 
liability for 2006 the $1,174 of earnings attributable to T's 
exchange funds.

    (f) Effective dates--(1) In general. This section applies to 
transfers of property made by taxpayers after the date these 
regulations are published as final regulations in the Federal Register.
    (2) Transition rule. With respect to transfers of property made by 
taxpayers after August 16, 1986, but on or before the date these 
regulations are published as final regulations in the Federal Register, 
the Internal Revenue Service will not challenge a reasonable, 
consistently applied method of taxation for income attributable to 
exchange funds.
    Par. 4. Section 1.1031(k)-1 is amended by adding a sentence at the 
end of paragraph (h)(2) to read as follows:


Sec.  1.1031(k)-1  Treatment of deferred exchanges.

* * * * *
    (h) * * *
    (2) * * * For rules under section 468B(g) relating to the current 
taxation of qualified escrow accounts, qualified trusts, and other 
escrow accounts, trusts, and funds used during deferred exchanges of 
like-kind property, see Sec.  1.468B-6.
* * * * *
    Par. 5. Section 1.7872-16 is added to read as follows:


Sec.  1.7872-16  Loans to an exchange facilitator under Sec.  1.468B-6.

    (a) Special rules applicable to loans made to an exchange 
facilitator under Sec.  1.468B-6--(1) Scope. This section applies to a 
transaction that, under Sec.  1.468B-6(c)(1), is treated as a loan to 
an exchange facilitator in connection with a deferred exchange 
(exchange facilitator loan). For purposes of this section, the terms 
deferred exchange, exchange agreement, exchange facilitator, exchange 
funds, qualified intermediary, replacement property, and taxpayer have 
the same meanings as in Sec.  1.468B-6(b).
    (2) Treatment as compensation-related loans. If an exchange 
facilitator loan is a below-market loan, the loan is treated as a 
compensation-related loan under section 7872(c)(1)(B).
    (3) Treatment of exchange facilitator loan as a demand loan. For 
purposes of section 7872, exchange facilitator loans are treated as 
demand loans.
    (4) 182-day rate for exchange facilitator loans. For purposes of 
section 7872(f)(2), in lieu of the applicable Federal rate (AFR) 
provided under section 1274(d)(1), the taxpayer and the exchange 
facilitator must use the 182-day rate for an exchange facilitator loan. 
For purposes of the preceding sentence, the 182-day rate is equal to 
the investment rate on a 182-day Treasury bill determined on the 
auction date that most closely precedes the date that the exchange 
facilitator loan is made.
    (5) Use of approximate method permitted. The taxpayer and exchange 
facilitator may use the approximate method under Sec.  1.7872-13(b)(2) 
to determine the amount of forgone interest on any exchange facilitator 
loan.
    (b) No exemption for below-market exchange facilitator loans. If an 
exchange facilitator loan is a below-market loan, the loan is not 
eligible for the exemptions listed under Sec.  1.7872-5T(b), including 
Sec.  1.7872-5T(b)(14) (relating to loans without significant-tax 
effect).
    (c) Example. The provisions of this section are illustrated by the 
following example.

    Example. (i) T enters into a deferred exchange with QI, a 
qualified intermediary. The exchange is governed by an exchange 
agreement. The exchange funds held by QI pursuant to the exchange 
agreement are treated as loaned to QI under Sec.  1.468B-6(c)(1). 
Under paragraph (a)(1) of this section, the loan between T and QI is 
an exchange facilitator loan. The exchange agreement between T and 
QI provides that no earnings will be paid to T. On December 1, 2006, 
T transfers property with a fair market value of $1,000,000 to QI 
and QI deposits $1,000,000 in a money market account. On March 1, 
2007, QI uses $1,000,000 of the funds in the account to purchase 
replacement property identified by T, and transfers the replacement 
property to T. The amount loaned for purposes of section 7872 is 
$1,000,000 and the loan is outstanding for three months. The 182-day 
rate under paragraph (a)(4) of this

[[Page 6238]]

section is 1 percent, compounded semi-annually.
    (ii) Under paragraph (a) of this section, the loan from T to QI 
is treated as a compensation-related demand loan. Because there is 
no interest payable on the loan from T to QI, the loan is a below-
market loan under section 7872. Under section 7872(e)(2), the amount 
of forgone interest on the loan for 2006 is $833 ($1,000,000*.01/
2*1/6). Under section 7872(e)(2), the forgone interest for 2007 is 
$1667 ($1,000,000*.01/2*2/6). The $833 for 2006 is deemed 
transferred as compensation by T to QI and retransferred as interest 
by QI to T on December 31, 2006. The $1667 for 2007 is deemed 
transferred as compensation by T to QI and retransferred as interest 
by QI to T on March 1, 2007.
    (d) Effective date. This section applies to exchange facilitator 
loans issued after the date these regulations are published as final 
regulations in the Federal Register.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 06-1038 Filed 2-3-06; 8:45 am]
BILLING CODE 4830-01-P