25 th Annual Texas Federal Tax Institute: Meltdowns in the Section 1031 Neighborhood

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1 25 th Annual Texas Federal Tax Institute: Meltdowns in the Section 1031 Neighborhood Bradley T. Borden Kevin Thomason Todd D. Keator Washburn University Thompson & Knight LLP Thompson & Knight LLP School of Law Dallas, Texas Dallas, Texas Topeka, Kansas 1

2 General Outline Industry Overview Recent QI failures The LandAmerica debacle Millard Refrigerated Services, Inc. v. LandAmerica 1031 Exchange Services, Inc. Exchange Fund Security Workout-Driven Exchanges 2

3 Recent QI Failures Southwest Exchange, Inc. (2007) $97,500,000 in exchange funds $91,700,000 recovered mainly from third parties Employees indicted on criminal charges 1031 Tax Group (2007) Regional Roll-ups Ed Okun convicted of 23 counts, including mail fraud, wire fraud, money laundering 3

4 LandAmerica Bankruptcy QI invested float in auction rate securities (ARS) to boost revenues ARS market froze Chapter 11 Bankruptcy on November 26, 2008 $416,000,000 in claims 400 commingled accounts 50 segregated accounts REIT with $137 million in a qualified escrow with a 3P bank settled for $135 million 4

5 Millard Refrigerated Services, Inc. v. LandAmerica 1031 Exchange Services, Inc. TP deposited funds with LES in a segregated account not qualified trust/escrow account Segregated account established for compliance with 468B regulations TP argued the funds were held in trust and not part of LES bankruptcy estate Court held the arrangement was debtor/creditor, not a trust 5

6 Millard, continued Court s Reasoning: Virginia law of trusts applied Exchange agreement granted the QI sole and exclusive possession, dominion, control and use of all Exchange Funds, and exchanger had no right, title or interest in any of the Exchange Funds No express language creating a trust Segregated account used only for 468B compliance Millard chose QI safe harbor, not qualified escrow or qualified trust safe harbor 6

7 Losses to Exchangers Using Failed QIs Tax Gain recognition on day 180? Character of loss? Contractual Leasing relinquished property Purchase of replacement property 7

8 Exchange Fund Security Exchange funds are an unsecured loan to the QI. TP due diligence: Some QIs better than others. Some form documents do not comply with the safe harbor and must be revised. Form documents usually drafted in favor of the QI and should be negotiated prior to signing. 8

9 Exchange Fund Security Possible methods to secure exchange funds: Seek a fidelity bond and a guarantee from the QI s parent Demand dual signature accounts Ask the QI s parent to form a single-member, bankruptcy-remote LLC (an SPE) to serve as the QI Combine QI safe harbor with the qualified escrow or qualified trust safe harbors Obtain a qualified letter of credit 9

10 Workout-Driven Exchanges - Example TP s property: Original price = $150 FMV = $50 AB = $20 Nonrecourse debt = $100 Lender threatening foreclosure If no 1031 exchange: TP has gain of $80 (Tufts) Tax with no recapture = $ gain taxed at 25% = $20 Can 1031 apply? Probably yes No requirement that QI hold cash or property Deed-in-lieu agreement may be assigned to QI TP must assume $100 of debt on replacement property, or pay cash of $100, or some combination, in order to avoid boot gain RPP will require substantial down payment, but this can be funded with foregone tax (e.g., $12 down and $88 debt) 10

11 Issues in Workout-Driven Exchanges If lender will not accept a deed-in-lieu, can TP still do a 1031 exchange? Deed property to QI prior to judicial or nonjudicial foreclosure. Problems: Can TP find a QI willing to take title to foreclosure property? Does QI satisfy 1031 regulatory requirement that QI must transfer the relinquished property to the buyer if the sheriff or trustee signs the deed and makes the conveyance? If recourse debt, part may be COI income In prior example, $30 would be gain from sale, and $50 would be COI income (ineligible for 1031). 11

Section 1031 Qualified Intermediaries and the New Economy

Brooklyn Law School From the SelectedWorks of Bradley T. Borden Fall 2009 Section 1031 Qualified Intermediaries and the New Economy Brad Borden Available at: https://works.bepress.com/brad_borden/28/ SECTION1031