Section 1031 Tax Deferred Exchanges: Safeguarding Exchange Proceeds
By: JEFFREY R. BENSON
February 2010
In a tax-deferred exchange under § 1031 of the Internal Revenue Code, the seller/exchangor of the relinquished property may not take receipt or constructive receipt of the sale proceeds. Typically, pursuant to one of the safe harbors provided in the regulations, a qualified intermediary (QI) is engaged to hold the proceeds and facilitate the disposition of the relinquished property and acquisition of the replacement property. It is not uncommon for the proceeds to be many millions of dollars. Yet too often exchangors have turned over these considerable proceeds to the exchange services company serving as the QI without careful consideration of the risks involved.
One of the obvious risks is misappropriation or fraud. Two high-profile QI failures illustrate this risk. In January 2007 Southwest Exchange, Inc., a large regional exchange services company, failed with nearly $100 million of exchange funds unaccounted for. Later that same year, the 1031 Tax Group filed for bankruptcy with over $130 million in exchange funds missing. Both cases involved formerly reputable exchange companies (1031 Tax Group was a rollup of a number of reputable regional QIs) that were acquired by new ownership that allegedly raided the exchange proceeds to fund extravagant personal lifestyles and dubious business ventures.
Bad investment is another risk. Exchange companies have profited, sometimes significantly, from the spread between the stipulated investment return on exchange funds that the QI agrees to pay to the exchangor and the investment return the QI receives from its investment of pooled exchange funds. Those investments, however, are not without risk, as illustrated by the November 2008 failure of LandAmerica 1031 Exchange Services. In that case exchange funds were invested in auction rate securities. When the market for those securities froze, LandAmerica ultimately became unable to meet its obligation to make the proceeds available to acquire replacement properties. Some 450 exchangors became mired in its bankruptcy proceeding, involving over $400 million in claims.
Not unlike how a Ponzi scheme operates, a failing QI can mask fraud or malinvestment for a time by using new-customer proceeds to finance pending replacement-property acquisitions, but eventually the enterprise will collapse on itself and end up in bankruptcy.
If the QI goes into bankruptcy, as illustrated by decisions in the LandAmerica case, it is likely that exchange funds held in the name of the QI will be deemed part of the QI’s bankruptcy estate. This may be true regardless of whether the funds are commingled with funds of other exchangors, held by the QI in a segregated subaccount for a specific exchangor, or even if held by the QI in a separate account established specifically for these particular proceeds. This means the exchangor could be treated as any other unsecured creditor of the bankrupt QI and might well end up losing a considerable percentage of its exchange proceeds.
Moreover, even if the exchangor is fortunate enough to ultimately recover most of its exchange proceeds, the delay resulting from the bankruptcy proceedings could have other serious consequences. It is likely the exchangor will miss its tax deadline for acquiring the replacement property. The delay may also cause the exchangor to default on its contractual obligations to the replacement property seller. The unfortunate result will be tax liabilities from the blown exchange, together with the forfeited earnest money and other potential contract damages if the exchangor is unable to perform its obligations under its replacement property purchase agreement.
So how can the exchangor protect its exchange proceeds from these risks?
For starters, the exchangor needs to do its due diligence. The exchangor will want to make sure the QI is qualified, experienced, and reputable. The exchangor should also understand how the exchange proceeds will be held and invested by the QI.
The exchangor, however, should not rely on due diligence alone and needs to consult with its tax advisor and attorney regarding structures that add additional protections for the exchange funds without violating regulatory requirements for exchange treatment. These structures include the following:
- Require a Guaranty. Typically exchange companies serving as QIs do not have significant assets other than the funds they are holding for customers. But they are usually affiliated with title companies or other institutions that are creditworthy and have substantial net worth. If the exchange funds are going to be held by or in the name of the QI, the exchangor should insist that the parent company provide a guaranty of the QI’s liabilities and obligations under the exchange agreement. Of course, the exchangor needs to make sure that it has gone far enough upstream in the organizational chart to identify a guarantor that has the wherewithal to perform upon QI failure.
- Use a qualified escrow or qualified trust account. When a qualified escrow account is used, the exchange funds go directly into an escrow account established with a depository bank that serves as the escrow agent, and the QI never takes possession of the funds. This structure is one of the safe harbors provided in Treasury regulations and can be used in conjunction with the QI safe harbor. The requirements that must be met in order for an escrow or trust account to qualify for the safe harbor are outlined in the regulations but are beyond the scope of this article. Although use of a qualified escrow account alone may not be sufficient to keep the exchange proceeds from initially being caught up in an automatic bankruptcy stay, it offers the best likelihood that exchange funds will not ultimately be deemed part of the bankrupt QI’s estate. A qualified escrow account has two additional benefits. First, the funds are placed in a segregated escrow account and cannot be withdrawn without the exchangor’s authorization, eliminating the risk of fraud or misuse of the funds. Also, the exchangor can receive periodic reports directly from the depository bank on the status of the account. Second, the exchangor has a say in the depository institution that will serve as the escrow agent, using a bank it knows is financially sound.
Other structures can be used either alone or in combination with the above to provide additional security. For example, the Q2’s obligations can be backstopped with a qualified standby letter of credit. In certain situations the exchangor might be well advised to require that the exchange company create a separate bankruptcy remote entity whose only purpose will be to serve as QI just for the exchangor’s particular transaction.
Takeaway
With any 1031 exchange the exchangor should be aware of the risks described above and should give careful consideration to the various structures available, within the parameters permitted by the regulations, to secure the exchange funds and reduce those risks. To this end, the exchangor needs to work closely with its tax advisor, with a knowledgeable attorney, and with an experienced and reputable exchange services company that is willing to tailor the structure to the exchangor’s particular needs.