Revisiting and Clarifying Aspects of 1031 Exchanges

Introduction

Section 1031 of the Internal Revenue Code provides that "[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment."¹ One theory behind the deferred tax treatment of Section 1031 exchanges is that when a property owner reinvests the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. Another theory is that the property owner has not really disposed of any interest in the property because the property owner’s new holding is of a "like kind." This article highlights several issues an investor should consider when structuring a 1031 transaction to ensure that the investor is not inadvertently taxed.

There are three kinds of 1031 exchanges. In a "forward" exchange, the taxpayer sells the "relinquished" property first, and buys the "replacement" property second, usually from a different party. In a "reverse" exchange, the taxpayer buys the "replacement" property first and sells the "relinquished" property second. In a true "simultaneous" exchange, two parties exchange deeds.

Using a Qualified Intermediary for a Simultaneous Exchange

In any 1031 exchange, the recognized gain and resulting taxes may only be deferred if the taxpayer does not actually or constructively receive money or other property before the taxpayer actually receives the like-kind replacement property. A qualified intermediary (QI) is used in a forward exchange to prevent the taxpayer from constructively or actually receiving the sale proceeds. In a true swap, real property of the same value is transferred concurrently between the parties. In this kind of simultaneous exchange, a QI is unnecessary because there is no constructive receipt, as there is no interval of time between the sale of one property and the purchase of the replacement property.

QIs may be necessary, however, in a simultaneous exchange in which the properties exchanged are not of equal value. In such a transaction, one party will receive cash along with the replacement property to account for the difference in value. This cash may qualify as taxable "boot" for the party who receives it, unless a QI holds the cash until the taxpayer identifies, and closes on, the acquisition of additional replacement property.

QIs can also be useful in simultaneous exchanges, especially those that involve more than two parties. A QI can act as a safety net in case the exchange does not turn out to be in fact simultaneous. If the investor sells its property, but the purchase of the replacement property is delayed, the investor may be deemed to have constructively received the cash proceeds from the sale of the relinquished property if a QI is not used. By using a QI and structuring the transaction as a forward exchange that happens to be occurring simultaneously, an investor can avoid this potential risk. Therefore, even in transactions in which a QI is not required, it may be worth the fee to obtain the protection they provide.²

The Pennsylvania Transfer Tax and the 1031 Exchange

In November 2007, the Department of Revenue (the Department) substantially revised its realty transfer tax regulations. As a consequence of those revisions, the Department’s treatment of Section 1031 exchanges was substantially modified. Prior to the revisions, intermediaries, such as a QI and an exchange accommodation titleholder (EAT), were considered agents for their principals under the "straw party" exemption to the realty transfer tax. As such, the transfers of properties to and from these intermediaries in the course of a 1031 exchange were considered non-taxable transfers. Thus, in a typical forward exchange, there were two taxable transfers rather than four. Under Section 91.153 of the new regulations, however, QIs and EATs are no longer considered straw parties, and transfers to and from QIs and EATs are subject to the transfer tax.

As a consequence of numerous inquiries about the 2007 regulations, the Department issued Realty Transfer Tax Bulletin 2008-01, which clarified that, if structured properly, forward exchanges could still achieve exemption from the state’s realty transfer tax. The Department provided several hypothetical scenarios demonstrating when the transfer to a QI is taxable. The general rule is that if the QI "never takes title or has dominion over" the exchanged properties, as in the typical forward exchange, then the transfer tax is not implicated. A realty transfer tax will not be imposed if the QI merely acts as a facilitator of the conveyances for the relinquished and replacement properties by holding cash. In a reverse exchange transaction, in which an QI is used to hold title to the replacement property until sale of the relinquished property, the conveyance of the replacement property to and from the QI will be taxed.

Protecting Assets When Held By a Qualified Intermediary

In a monumental decision by the United States Bankruptcy Court for the Eastern District of Virginia, the court held that sale proceeds being held in escrow for the purpose of a 1031 exchange were property of the bankrupt QI’s estate. LandAmerica 1031 Exchange Services, Inc. filed bankruptcy at a time when it was holding $420 million for 450 of its customers waiting to complete their various transactions. In this particular case, Millard Refrigerated Services assigned to LandAmerica its rights as seller under purchase agreements for three separate properties. The exchange funds were moved into separate sub-accounts associated with Millard’s name and taxpayer identification number. Only LandAmerica had control over the accounts, and the parties agreed that LandAmerica could earn interest or other fees on the accounts.

The court decided that the funds were the property of LandAmerica’s bankruptcy estate even though they had been put into separate accounts for Millard. The court stated that the exchange agreements specifically gave all "right, title, and interest" and "dominion, control, and use" over the exchange funds to LandAmerica. Furthermore, the court found that no trust existed under Virginia law because no express words like "trust," "trustee," or "beneficiary" were used in the exchange agreements. The court held that the relationship between LandAmerica and Millard was actually that of creditor and debtor, and not of trustee and beneficiary. In such a relationship, LandAmerica was under no fiduciary duty to deal with the property for the benefit of Millard.

In the future, investors seeking to use QIs should carefully scrutinize the risk of having exchange funds become subject to claims by the QI’s creditors. Investors should verify that the QI is holding the funds as an agent for the seller in a separate account. Current treasury regulations provide as an alternative to using a QI that the sale proceeds can be held in either a qualified escrow account or qualified trust account. Accordingly, investors should also make sure that the exchange agreement with the QI is drafted to clearly establish that the QI will hold the exchange funds in trust, or as agent, for the investor.

Endnotes

1 In a 1031 transaction, the gain inherent in the relinquished property (and the attendant taxes that may be due as a result of that gain) is deferred until the disposition of the replacement property.

2 QIs usually charge a flat fee for their services. Generally, fees for a reverse exchange are significantly higher than for a forward exchange.