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
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 firstname.lastname@example.org.
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