In November 2008, LandAmerica 1031 ExchangeServices, Inc. (LandAmerica) filed for Chapter 11bankruptcy citing a downturnin the real estate marketand its investment in highyieldauction–rate securitiesas reasons for its filing. Asa result of the bankruptcyfiling, hundreds of real estateinvestors – hoping to takeadvantage of a real estate taxstrategy known as a 1031exchange – have been left inlimbo as they wait to find outif or when they will get theirmoney back.
A 1031 exchange is astrategy and method forselling one qualified propertyand then proceeding withan acquisition of anotherqualified property within aspecific time frame in order todefer paying any capital gainstax related to the sale.
In a 1031 exchange, ataxpayer cannot receive any ofthe proceeds generated fromthe sale of the relinquishedproperty. Because of this,taxpayers typically use aqualified intermediary to takethe proceeds (i.e., the 1031funds) from a sale, hold it forthe taxpayer and then deliverit at the closing of a qualifiedtransaction where the fundsare used to acquire the secondproperty.
Among the hundreds ofinvestors at Land America,only 50 of them had their 1031funds placed in segregatedaccounts. The remaininginvestors had their funds placedin commingled accounts makingit likely that these funds are nowpart of the bankruptcy estate ofLand America.
As is invariably the case inhard times, there are lessons tobe learned. The Land Americaepisode highlights the need forreal estate investors to be extravigilant about protecting their1031 funds. There are a numberof measures that should be takenin order to maximize protectionof your 1031 funds whencompleting a 1031 exchange.
1. Request that your1031 funds be placed insegregated account(s). As theLand America situation hasshown us, if 1031 exchangefunds become commingledwith funds belonging to thequalified intermediary, andthe qualified intermediary filesfor bankruptcy, the exchangefunds could become partof the bankruptcy estate ofthe qualified intermediary.Should this occur, an investoris relegated to the status ofan unsecured creditor of thequalified intermediary. Tominimize this possibility, requirea qualified intermediary to holdyour 1031 funds in a segregatedaccount to prevent them frombeing commingled with those ofother clients of the intermediary.
2. Specify how the qualifiedintermediary invests your 1031funds. Pay careful attention tohow the qualified intermediarywill handle your funds.According to its bankruptcyfiling, the failure of LandAmerica was due in part to itsinvestment of investor 1031funds in high–yield, auctionratesecurities. One of thecasualties of the credit crisishas been the collapse of theauction–rate securities market.As a result, when the market tobuy the auction–rate securitiesdisappeared, Land America wasunable to sell the securities itheld.
Take precautions to ensurethat your funds are affordedproper protection undercurrent FDIC insurancecoverage amounts. Many 1031transactions involve deposits inexcess of the maximum FDICinsurance coverage amounts.In these situations, ask yourqualified intermediary to investthe 1031 funds in a non–interestbearing transaction accountat an institution participatingin the FDIC’s TemporaryLiquidity Guarantee Program.This will allow the investor totake advantage of the FDIC’sTransaction Account GuaranteeProgram which will fully insureits exchange funds throughDec. 31, 2009. In the alternative,investors wishing to investtheir funds in interest–bearingaccounts can request their1031 funds be collateralized bygovernment–backed securities orsecured by a surety bond.
This article is intended as abrief overview of some of themeasures that can be taken tomaximize protection of your1031 funds. Please contact yourlegal and financial professionalsfor additional information.
