Sunday, May 24, 2009

EXTREME CARE NEEDED WHEN USING QUALIFIED INTERMEDIARIES IN SECTION 1031 EXCHANGES

Section 1031 of the Internal Revenue Code allows taxpayers to exchange real property and other types of property for property of “like-kind.” Since it is rare to find a buyer and seller with two properties that each is willing to exchange directly to the other, the Code allows for a deferred exchange where the seller sells his property, with the proceeds being used to buy a replacement property from a third party within certain time limits. As part of this exchange process, the seller cannot take into his or her own possession the sale proceeds from the sale of his property. One method of conducting such exchanges while keeping the sale proceeds out of the hands of the seller is to use a facilitator, or “qualified intermediary” (QI).  The QI usually takes title to the property from the seller, sells the property, holds the sale proceeds, and then acquires the replacement property which it exchanges back to the original seller.

The QI business is big business, with many millions of dollars of cash and properties passing through the hands of the QI’s each year. Like any business, a QI can fail and go under. What happens to the funds the QI is holding that are in the middle of an exchange if the QI goes into bankruptcy?

For customers of Landamerica, they are learning the hard way that their funds may be lost. Landamerica’s Section 1031 customers had $420 million with Landamerica that were in the middle of their swaps when the company went into bankrutpcy. The 450 customers claimed that their cash was held either in escrow or in trust, so they should be able to get all of their money back. The bankruptcy trustee argued that since no true escrow or trust was established to hold the funds, the customers are merely general, unsecured creditors of Landamerica. This means that they will be paid only after the secured creditors of the company are paid, and then only pro rata with all other unsecured creditors of the company.

In a ruling last year as to “segregated accounts,” and a ruling earlier this month as to other Section 1031 accounts, the Bankruptcy Court held that the funds of the customers were not held in trust or escrow, and that the customers are mere unsecured creditors. Therefore, it is unlikely that the customers will be made whole on their swap funds.

To make matters worse for these unfortunate customers, their swap funds were invested in auction-rate securities, which are difficult to value and may be substantially impaired in today’s poor credit market. Further, as time goes on, the attorney fees relating to the bankruptcy continue to further deplete the funds available for repayment to creditors.

The real tragedy here is that with proper structuring, as noted by the Bankruptcy Court itself, it should have been possible to both avoid these bankruptcy problems and still obtain Section 1031 deferred gain treatment. Further, contractual limitations could have been used to assure that the funds were invested in more conservative cash investments.

In re Landamerica Financial Group, Inc., 2009 WL 1269578
Bkrtcy.E.D.Va., May 07, 2009

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