Savvy real estate investors know they can avoid paying income taxes on the sale of appreciated real estate by purchasing "like-kind" exchange property. But what happens when the intermediary holding sale proceeds on behalf of a seller files for bankruptcy in the middle of the transaction? In the recent case of Millard Refrigerated Services, Inc. v. LandAmerica 1031 Exchange Services, Inc., the United States Bankruptcy Court for the Eastern District of Virginia decided that sale proceeds were the property of the bankrupt intermediary's estate and did not belong to the seller. Based on this decision, a seller embarking on a 1031 exchange must exercise extra caution to protect its sale proceeds from the intermediary's creditors.

What Is a 1031 Exchange?

A 1031 exchange allows a taxpayer to defer the payment of tax that otherwise would be due upon the realization of capital gains on the disposition of business or investment property. In the typical transaction, a seller assigns its rights under a purchase agreement to a qualified intermediary, and the purchaser of the relinquished property transfers the net sales proceeds directly to that entity.

Under Internal Revenue Code Section 1031, the seller initiating an exchange must identify like-kind replacement property within 45 days of the sale. The exchanger has 180 days after the conveyance of the relinquished property to close on the replacement property. If the replacement property is not identified or the closing is not completed within the specified time periods, the qualified intermediary must pay the net proceeds from the sale of the relinquished property to the exchanger, who forfeits the opportunity to defer capital gains taxes. If the requirements are met, however, the qualified intermediary purchases the replacement property and then transfers it to the exchanger. The entire transaction is governed by a written exchange agreement executed by the exchanger and the qualified intermediary.

Recent Case Law

In the Millard case, the exchange intermediary, LandAmerica 1031 Exchange Services, Inc. (LES), filed for Chapter 11 bankruptcy protection while holding money in its bank accounts to facilitate three like-kind exchange transactions for Millard. Prior to its bankruptcy filing, LES had invested some of its customers' exchange funds in auction rate securities that became illiquid as credit markets froze. Millard was one of more than 85 adversary proceedings brought by former customers of LES after it declared bankruptcy. In each case, the former customer asserted that the money deposited by LES was held in trust for the customer's benefit and should be returned to it.

The bankruptcy court disagreed, noting that the exchange funds transferred to LES's bank accounts were under its complete control. Therefore, only LES had the power and authority to disburse or withdraw the funds. Although Millard argued that LES held the funds in trust for its benefit, the court determined that under Virginia law (which specifically applied to the exchange agreements) no trust existed because there was no express language in the exchange agreements that created a trust. To the contrary, the exchange documents conveyed exclusive possession, dominion and control of the exchange funds to LES. Since LES was described in the agreements only as a "qualified intermediary" and not as a "trustee," the court found evidence that no implied trust was intended and, therefore, LES was under no fiduciary duty to deal with the property for the benefit of Millard. As a result, the money deposited with LES prior to its bankruptcy filing now belongs to the bankruptcy estate—not Millard.

Sellers Take Note

Whether the parties to an exchange agreement intend to create a trust is determined by state law. The decision in the Millard case is being appealed, and there is no guarantee that a court sitting in Illinois would reach the same result. But the lesson is clear: before entering into a like-kind exchange agreement with a qualified intermediary, it is critical that a seller of real estate or other investment property thoroughly understand the implications of the documents used to secure the intermediary's obligations. In the current economic climate, particularly on the heels of the Millard decision, even the most experienced investor would benefit from a review of the qualified intermediary's documents by an attorney who is experienced in 1031 exchanges and related transactions.