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 record keeping 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 that 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.

This month’s Tales from the Vault looks at another problem encountered by a purchaser who was forced to deal with the bank’s affiliated title company.

When Harry was looking at the house he wanted to buy, his realtor pointed out to him that the house violated neighborhood setback lines, but that the current owner and seller had been able to get title insurance over the violation due to the length of time the house had been constructed.  He told Harry he would get him a copy of the title policy so Harry could tack onto it and get the same coverage.  Harry was given a copy of the title policy, and he took it to his attorney and asked him to tack onto it so he could get the same coverage over the setback violation.  After the closing when Harry received his title policy he noticed it was not only from a different company but that it did not have any coverage over the setback line violation.  When he brought the issue up with his attorney, Harry was told the attorney had to use the bank’s title company or risk being removed from their approved list.

Harry then asked about getting affirmative coverage over the setback violation from this company and his attorney said he had requested affirmative coverage, but that the title company had declined to give it, notwithstanding the fact the previous title company had given the coverage.  He told Harry he was sorry, but there was nothing else he could do.

Was there anything else the attorney could have done?  Did Harry’s attorney have to use the banks title company?

North Carolina General Statutes Section 75-17 states:

Lender may not require borrower to deal with particular insurer.

No person, firm, or corporation engaged in lending money on the security of real   or personal property, and no trustee, director, officer, agent, employee, affiliate, or associate, of any such person, firm, or corporation, shall either directly or indirectly require or impose as a condition precedent

(1)       To financing the purchase of such property, or

(2)       To lending money upon the security of a mortgage, deed of trust or other security instrument, or

(3)       For the renewal or extension of any such loan, mortgage, or deed of trust, or

(4)       For the performance of any other act in connection therewith, that such person, firm or corporation

a.  For whom such purchase is to be financed, or

b.  To whom the money is to be loaned, or

c.  For whom such extension, renewal, or other act is to be granted, negotiate, procure, or otherwise obtain any policy of insurance or renewal, or extension thereof, covering such property, or a security interest therein, by or through a particular insurance company, agent, broker, or other person so specified otherwise designated in any manner by the lenders, or their agents or employees or affiliated or related companies. (1969, c. 1032, s. 1.)

North Carolina law makes it very clear that no bank can require the use of a particular title company.  NCGS Section 75-19 specifies what the penalties are for violation of this statute.

Violators subject to fine and injunction.

The superior court, on complaint by any person that G.S. 75-17 or G.S. 75-18 is being violated, may issue an injunction against such violation and may fine all persons, firms, corporations, and officers, directors, trustees, agents, employees, or affiliates of such up to two thousand dollars ($2,000) per person for such violation. In event of a disregard of such injunction or other court order, the superior court shall hold such parties in contempt and prescribe such further penalties as the court in its discretion shall so determine. The clear proceeds of fines provided for in this section shall be remitted to the Civil Penalty and Forfeiture Fund in accordance with G.S. 115C-457.2. (1969, c. 1032, s. 3; 1998-215, s. 100.)

It is clear from these statutes that banks cannot specify what title company their borrowers must use and yes Harry does have a remedy that he may pursue against this lender.