Goodwin Procter's Andrew Kirsh

LES held and invested millions of dollars for hundreds of sellers until the exchange funds were used to acquire replacement property. Then, on November 26, 2008, it filed for Chapter 11 protection. Now hundreds of sellers are asking: What happened to my 1031 exchange funds?

A Now Too Familiar Story

LES appears to be another casualty of the credit crunch and risky investment. It pooled much of the money it received from exchange transactions into commingled accounts and then invested those funds in auction-rate securities. As funds became needed to acquire replacement properties, LES would liquidate a portion of its investments and use the cash to complete the 1031 exchanges. However, when the credit markets froze, including the market for auction-rate securities, LES was unable to liquidate its investments at a price close to par value and, therefore, was unable to meet the cash needs of its customers intending to complete their 1031 exchanges. Consequently, bankruptcy became the only option for LES.

Now, its customers are scrambling to recover their sales proceeds so they can complete their 1031 exchanges without suffering tax consequences. The reality is that many customers will not be able to complete these 1031 exchanges and, in the worst-case scenario, may face capital gains taxation despite the loss of sales proceeds upon which such taxes were derived.

As evidenced by the LES bankruptcy, deferred 1031 exchanges, if not properly structured, can be risky transactions. By taking certain precautions, real estate investors can attempt to mitigate the risks inherent in these transactions. Moreover, recent state legislation has been enacted to provide modest protections in this largely unregulated industry.

Selecting a Qualified Intermediary

Any person or entity may become a qualified intermediary by meeting the limited criteria imposed by the IRS or state legislation. For example, recently enacted California Senate Bill SB 1007 merely requires qualified intermediaries to maintain a minimum amount of bond coverage of $1 million and E&O insurance coverage of $250,000. With a limited barrier to serving as a qualified intermediary in place, any real estate investor performing a 1031 exchange must select a reputable qualified intermediary with a proven track record.

In this case, size does not matter as LandAmerica was the third largest title insurance underwriter in the United States. The focus should not be on the breadth of the qualified intermediary's affiliates and subsidiaries but rather on the balance sheet and history of financial reporting and disclosure of the qualified intermediary.

Segregated Account

Qualified Intermediaries enter into agreements with customers that govern the ownership and control of the exchange funds. When negotiating these agreements, real estate investors should insist that their funds be placed in a segregated account which are not commingled and are separately identified with an investor's name and federal tax identification number. Of the 450 customers who currently have exchange funds with LES, approximately 50 required LES to segregate its funds from the commingled pool LES controlled.

The Bankruptcy Court overseeing the LandAmerica bankruptcy will preside over test claims asserted by certain LES customers to resolve the question of ownership of the alleged segregated and commingled exchange funds. It is more likely that the Court will find that the commingled accounts, as opposed to the segregated accounts, constitute property of the debtor's estate and that these customers will be unsecured creditors who must stand behind any secured creditor-claimants. Although through SB 1007 the California legislation is attempting to protect investors by prohibiting the commingling of exchange funds with the operating accounts of Qualified Intermediaries, without prohibiting the commingling of exchange funds among investors, 1031 exchange customers will continue to be at risk.

Investing Exchange Funds

An agreement with qualified intermediaries should specifically identify the permissible investments for exchange funds and financial institutions in which the funds are invested. Because exchange funds are needed to purchase replacement property within 180 days after the initial sale, qualified intermediaries should invest in short-term, low-risk investments, such as FDIC-insured deposit accounts, money market accounts or other cash-like securities. In fact, SB 1007 requires exchange funds to be invested in accordance with the prudent investor standard and satisfy investment goals of liquidity and preservation of principal. As such, it remains left up to qualified intermediaries to reach the conclusion that investments, such as auction-rate securities, represent an illiquid and long-term investment that will violate the standard.

Conclusion

The LandAmerica bankruptcy has caused the real estate industry to re-examine the risks associated with 1031 exchanges. By selecting proper Qualified Intermediaries, placing exchange funds into segregated accounts and preventing illiquid investments, real estate professionals can continue to feel confident about the efficacy of 1031 exchange transactions as a valuable tax strategy.