Are your 1031 Like Kind Exchange Dollars Safe?
Sellers of appreciated investment real estate often avoid paying income taxes on the sale by reinvesting the sales proceeds in newly purchased “like kind” exchange property. But avoiding taxes became the least of the worries of the sellers in the recent case of Millard Refrigerated Services, Inc. v. LandAmerica 1031 Exchange Services, Inc. The like kind exchange agent, or intermediary, in this case declared bankruptcy in the middle of the transaction, and the U.S. Bankruptcy Court decided that the sales proceeds (held on behalf of the seller) were property of the bankrupt intermediary’s estate and did not belong to the seller. The effects of this decision are rippling through the real estate world. Sellers involved with or thinking about a so-called “1031” like kind exchange need to understand the new risks of retaining a 1031 intermediary.
Millard Refrigerated Services, Inc. v. LandAmerica 1031 Exchange Services, Inc. was part of over 85 separate cases brought by exchange customers of 1031 intermediary, LandAmerica, after it declared bankruptcy. The Court noted that prior to its bankruptcy filing, LandAmerica had invested some of its customers’ exchange funds in auction rate securities, a market that seized up, preventing LandAmerica from having the liquidity to meet all of its pending exchange obligations and acting, in part to trigger the bankruptcy filing. As a result, exchange customers were pitted against each other over control of LandAmerica’s limited remaining cash.
Using a two-step analysis, the Court decided that the exchange funds were the property of LandAmerica’s bankruptcy estate even though they had been put into a separate account specifically for the taxpayer (Millard’s) exchange. First, the Court ruled that the written exchange agreements specifically gave all "right, title and interest" in the exchange funds, and "dominion, control and use" over those funds, to LandAmerica. The Court’s second step was to determine whether LandAmerica controlled those funds (which it held in a segregated account) not as the owner, but as a trustee for its customer - the exchanging taxpayer. The Court found that no trust existed under Virginia law (which specifically applied to the exchange agreements) because no express words like "trust," "trustee" or "beneficiary" were used in the exchange agreements (the agreements actually disclaimed fiduciary duties that are essential in a trustee’s role). The Court found that the segregated accounts served only to allow tracing of the funds, not to evidence or create a trust (in fact, under the Treasury regulations exchanges involving more than $2,000,000 require a separate account to avoid treating the exchange funds as a loan to the intermediary). The Court emphasized that the Tax Code allows “safe harbor” use of qualified intermediaries, qualified trusts and qualified escrows for exchanges, and that the safe harbors were not exclusive - so a taxpayer had the option of choosing a safer arrangement. Since under the agreements LandAmerica was described only as a “qualified intermediary” and not a trustee, there was evidence that no implied trust was intended and, therefore, the exchange funds were the property of bankrupt LandAmerica – and available to satisfy LandAmerica’s creditors. Making matters even worse, the financial impact may not be limited to just losing the sales proceeds: the taxpayers in the affected exchanges also face an income tax liability from the sale of the appreciated asset, although there may be some offset for the loss of the exchange funds.
While the case is being appealed, the case stands as a stark warning that creditor protection is an absolute necessity for anyone in the process of or considering a like-kind exchange. These exchanges should be very carefully structured to ensure that their funds are not subject to the claims of the intermediary’s creditors. It is prudent to consider using a qualified trust or qualified escrow arrangement with a creditworthy intermediary serving as trustee or escrow agent under the detailed rules. For any pending transactions, it is critical to review the exchange documents and the escrow structure to avoid exposure to the intermediary’s creditors.
For more information, please contact Michael J. Radin at (617) 218-2035 or by e-mail at email@example.com.
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