So You Thought Your Proceeds Belonged To You? The Interplay Between Like-Kind Exchanges Under The Tax And Bankruptcy Codes

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1 So You Thought Your Proceeds Belonged To You? The Interplay Between Like-Kind Exchanges Under The Tax And Bankruptcy Codes Kevin J. Funk Kevin J. Funk is a principal in the Richmond, Virginia, law firm of DurretteBradshaw PLC. This article is based on a paper the author prepared for a presentation sponsored by the ABA Tort and Insurance Practice Section in August He would like to acknowledge Barrett E. Pope and J. Buckley Warden, IV of DurretteBradshaw, PLC and Michael S. Brady of Asset Preservation, Inc., for their review and input in these materials. Mr. Funk may be reached at kfunk@durrettebradshaw.com. What happens when facilitators of section 1031 exchanges fail? Although the concept of deferring capital gains taxes through an exchange of property for like-kind property is almost as old as the income tax itself, its use was largely limited to an actual exchange of properties between two people for decades. In the 1970s, adventurous tax professionals began structuring more complicated arrangements involving delayed and multi-party exchanges. These types of exchanges most often resulted in cash proceeds needing to be temporarily parked. Out of this need arose professional facilitators offering to hold the cash proceeds and apply them to the purchase of the new property. The Practical Tax Lawyer 43

2 44 The Practical Tax Lawyer Winter 2011 As the use of like-kind exchanges grew, so did the amount of money being held by these facilitators. Inevitably, the issue arose as to what happens if a facilitator becomes insolvent? What is the status of the funds held for third parties? Are these funds available to all creditors generally or are the parties who placed the funds there entitled to a higher priority? Courts have wrestled with these issues for more than two decades. The recent financial crisis has magnified these issues as some facilitators have filed for bankruptcy. Courts have been forced to address the legal relationship between a facilitator and the funds it holds. The holdings in cases such as In re LandAmerica Financial Group, Inc., the nations third largest title insurer and a significant facilitator of like-kind exchanges, have resulted in surprise among many, including tax professionals, causing some to ask, what is the future of like-kind exchanges? If there is any lesson emanating from these cases, it is that the shocking result was, in most cases, driven less by the statutory/regulatory language (something parties don t control) and more by the specific way the parties structured their transactions, i.e., the words they chose to use, the way the funds were handled, etc. (things the parties can control). As a result, it is imperative that lawyers and tax professionals understand the arguments for and against the facilitators ownership of these funds and the regulations being enacted across the country to respond to the recent spate of cases. This article provides an overview of the arguments that have been made by all sides in the dispute over ownership of exchange funds, a sample of the significant cases wrestling with the ownership of exchange funds, and a sample of the statutory and regulatory modifications that have been made in response to these decisions. Section 541 of the Bankruptcy Code The scope of section 541 is unquestionably broad. When a bankruptcy petition is filed, virtually all property of the debtor at that time becomes property of the bankruptcy estate. Section 541 of the Bankruptcy Code defines property of the estate broadly to include all of the debtor s interests, legal and equitable.in fact, every conceivable interest of the debtor, future, nonpossessory, contingent, speculative, and derivative, is within the reach of 541. In re Yonikus, 996 F.2d 866, 869 (7th Cir. 1993); see also 5 Collier on Bankruptcy (16th ed. 2010). Yet despite this broad reach, there are some limitations, as section 541(d) makes clear: (d) Property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, such as a mortgage secured by real property, or an interest in such a mortgage, sold by the debtor but as to which the debtor retains legal title to service or supervise the servicing of such mortgage or interest, becomes property of the estate only to the extent of the debtor s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold. Under section 541(d), if the debtor holds only legal title to the property but no equitable interest, such property belongs to the estate only to the extent of the legal interest. Thus, the estate property does not include the equitable interest. See In re Johnson, 232 B.R. 735 (Bankr. C.D. Ill. 1999) ( Under 541(d), where the debtor holds bare legal title without any equitable interest, the bankruptcy estate acquires only that bare legal title without any equitable interest. Id. at 740). Although section 541 determines which property interests are included in the bankruptcy estate, state law determines the extent of the debtor s property interests. Butner v. United States, 440 U.S. 48, 55 (1979). Thus, although bankruptcy law excludes equitable interests from the bankruptcy estate where the debtor only holds legal title, whether the debtor has an equitable interest is determined by state law. Section 1031 of the Tax Code Section 1031 allows a taxpayer to avoid paying capital gains taxes on the sale of property (most often real prop-

3 Like Kind Exchanges Under The Tax And Bankruptcy Codes 45 erty) if the taxpayer exchanges the sold property for like-kind property: 26 U.S.C Exchange of property held for productive use or investment. (a) Nonrecognition of gain or loss from exchanges solely in kind. (1) In general. No 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. Important Terms 1. Exchanger the taxpayer effecting the 1031 exchange. 2. Relinquished Property the property sold by the Exchanger on which capital gains tax would otherwise be owed. 3. Replacement Property the like-kind property purchased by the Exchanger. 4. Exchange Funds the cash proceeds from the sale of the Relinquished Property. Although enacted in 1954 (with predecessor statutes dating back to 1921), section 1031 was largely limited until the 1970s to actual exchanges of parcels of real property between two parties. Then courts began approving the use of delayed and multi-party exchanges. See Starker v. United States, 602 F.2d 1341 (9th Cir. 1979). To regulate the liberalization of the application of section 1031, the Treasury Department, in 1991, promulgated regulations on how such exchanges could be accomplished. Replacement Property must be identified within 45 days of the sale of the Relinquished Property and the exchange must be completed within 180 days of the sale of the Relinquished Property. Treas. Reg (k)-1. To maintain the legal fiction that there is an exchange of properties and not a realization of income, the taxpayer must not come into actual or constructive possession of the cash proceeds from the sale of the Relinquished Property. See Garcia v. Commissioner, 80 T.C. 491 (1983); Treas. Reg Safe Harbors To facilitate avoiding constructive or actual possession, the regulations establish four safe harbors. Safe harbors are mechanisms for exchanges, the use of which will not be the basis for a challenge to the validity of the exchange. Treas. Reg (k)- 1(g). Security Or Guaranty Arrangements The obligation to transfer the Replacement Property to the Exchanger may be secured by a mortgage or other security interest, a letter of credit, or a guaranty of a third party. Interest Or Growth Factors The Exchanger may earn money on the Exchange Funds. Qualified Intermediary If the Exchange Funds are held by a Qualified Intermediary ( QI ), the Exchanger will not be in constructive possession of the funds. A QI is someone who is not the agent of the Exchanger. The Exchanger assigns the sale contract for the Relinquished Property to the QI and the QI consummates the sale and takes possession of the sales proceeds. The Exchanger identifies the Replacement Property, the QI enters into an agreement with the seller of the Replacement Property, and the QI (i) pays for the Replacement Property and (ii) arranges for the deed to be transferred to the exchanger. A QI is treated as acquiring and transferring property if the QI acquires and transfers legal title to that property. Exchange Funds are sometimes commingled and sometimes segregated. The seller of the Replacement Property may deed the property directly to the Exchanger.

4 46 The Practical Tax Lawyer Winter 2011 Qualified Escrow Accounts And Qualified Trusts If the Exchange Funds are held by a qualified trust or escrow, the Exchanger will not be in constructive possession of the funds. Circumstances are substantially similar to those of a QI. QIs have been reluctant to use them because of the fear of implicating trust laws of the various states. Safe Harbors Are Not Mutually Exclusive More than one safe harbor can be used for one exchange as long as the requirements for each are separately satisfied. Treas. Reg (k)-1(g)(1). Reverse Exchanges Revenue Procedure , C.B. 308, promulgated in October 2000, effectively creates a new safe harbor when the Exchanger identifies his Replacement Property before he can sell the Relinquished Property. Under the Procedure, the Exchanger enters into a Qualified Exchange Accommodation Agreement with an Exchange Accommodation Titleholder ( EAT ). The EAT acquires the Replacement Property and parks it pending sale of the Relinquished Property. Insolvency of Qualified Intermediaries Since the use of delayed exchanges began, the legal status of the funds held by qualified intermediaries (the most-used safe harbor) has been the subject of debate. The issue most often arises when the QI becomes insolvent and therefore has insufficient assets to pay its creditors, as well as exchangers for whom the QI is holding cash proceeds. If a QI seeks bankruptcy protection, are the funds held for exchangers property of the QI s bankruptcy estate under section 541? Are the claims of the exchangers on an equal footing with the claims on non-exchanger creditors? Arguments have developed on both sides of the debate. Theories Suggesting That Exchange Funds Are Property Of The Estate Section 1031 Requires That The Exchanger Surrender All Interest In The Exchange Funds Some argue that, because (i) a section 1031 exchange requires that an Exchanger not come into actual or constructive possession and (ii) the deferment of capital gain is based on the fiction that there is an exchange of two parcels of property, then the nature of the transaction dictates that the Exchanger have no interest in the Exchange Funds. Consequently, the QI holds not only legal but also equitable title to them. In other words, if the Exchanger retained some interest in the Exchange Funds, a valid section 1031 exchange cannot occur. This argument fails in light of the plain language of the regulations and case law. Note that the Treasury regulations only require that the QI acquire and transfer legal title. See supra. Courts interpreting section 1031 have also held that the statute does not require that an Exchanger surrender its equitable interest in the Relinquished Property. A taxpayer need not abandon all equitable interest in the proceeds from the downleg property for a transaction to qualify as a non-taxable event under section Cook v. Garcia, 110 F.3d 67, 1997 U.S. App. LEXIS 5980 at *4 (9th Cir. mar. 27, 1997); see also In re Exchanged Titles, Inc., 159 B.R. 303 (Bankr. C.D. Cal. 1993). Rather than surrendering all interests, including equitable interests, the Exchanger s control of the property must be subject to substantial restrictions. Treas. Reg ; Garcia v. Comm r, 80 T.C. 491 (1983). Contract Qualified Intermediaries draft exchange agreements in such a way to ensure that the IRS will not later challenge the validity of the exchange, including making certain that the Exchanger has surrendered enough control over the Exchange Funds

5 Like Kind Exchanges Under The Tax And Bankruptcy Codes 47 that it will not later be deemed to have come into constructive possession of them. Clauses designed to deal with this concern include: [Exchanger] shall have sole exclusive possession, dominion, control, and use of all Exchange Funds Exchanger has no right title or interest in or to the Exchange Funds Although such language resolves concerns about constructive possession and substantial restrictions on the Exchanger s use of funds, they can be read to eliminate the Exchanger s equitable interest. When combined with a merger clause, the contractual language can preclude the finding of an express or implied trust. See In re LandAmerica 1031 Exchange Services, Inc., infra. Failure To Use Qualified Trust/Escrow Safe Harbor A QI is one of two forms of safe harbors using third-party facilitators. The other is qualified trusts or escrows. An Exchanger s failure to use a safe harbor called a trust or escrow in favor of a safe harbor that does not use such language indicates an intention not to create a trust. See In re LandAmerica 1031 Exchange Services, Inc., infra. Inability To Trace Even when a trust relationship is established, the party claiming a trust must identify the specific res. Once trust funds are placed into a commingled account, it is difficult, and, in some cases impossible to trace the trust funds. Accordingly, any trust that was ever created is lost. See In re LandAmerica 1031 Exchange Services, Inc., infra. Equity The primary policy of bankruptcy law is the equitable distribution among estate creditors. Imposing a trust on property that would otherwise be available to all creditors contravenes that policy. See In re San Diego Realty Exchange, Inc., infra. Theories Suggesting Exchange Funds Are Not Property Of The Estate Express Trust And Its Common Applications An express trust is created by the direct and willful acts of the parties, some writing or deed, or words expressly evidencing the intention to create a trust. The manifestation can be inferred and no particular words or phrases are necessary. 76 Am. Jur. 2d Trusts 17, 65 (2005). A settlor may create a trust for any lawful purpose, and the trust may be created for the settlor s own benefit as well as the benefit of another. The material purposes of a trust are subject to the settlor s discretion, which is limited only to the extent its purposes are lawful, not contrary to public policy, and possible to achieve. 76 Am. Jur. 2d Trusts 19 (2005). If the exchange agreement clearly indicates that it is the intention of the Exchanger to transfer property to the QI such that the QI is to hold the funds for the benefit of the Exchanger, a trust is created. The Exchange Agreement does not need to explicitly state that there is a trust. Resulting Trust And Its Common Applications A resulting trust is an equitable remedy use to prevent unjust enrichment and to ensure that legal formalities do not frustrate the original intent of the grantor. Such trusts arise when one person becomes invested with a legal title but is obligated in equity to hold his or her legal title for the benefit of another. See 76 Am. Jur. 2d Trusts 135 (2005). When a grantor grants property to another to be held in trust for the beneficiaries but the trust fails (e.g. no beneficiaries, beneficiaries disclaim, rule against perpetuities, etc.), the grantee holds the granted property in trust for the benefit of the grantor or the grantor s successors unless the purported trust document manifests an intent that a re-

6 48 The Practical Tax Lawyer Winter 2011 sulting trust not arise. See Restatement Third of Trusts 8 (2003). When a transfer of property is made to one person and the purchase price is paid by another, a resulting trust arises in favor of the person by whom the purchase price is paid. Exceptions include when the party paying the consideration manifests an intent that no resulting trust arise and when the transferee is a spouse, family member, etc. of the party paying the consideration. See Restatement Third of Trusts 7 (2003). A resulting trust theory could be applied to the Exchange Funds held by the QI in at least two ways. First, the Exchanger could argue that the exchange agreement purported to create a trust but failed to meet the technical requirements under state law. Alternatively, the Exchanger could argue that the Purchaser of the Relinquished Property transferred the Exchange Funds to the QI and the Exchanger provided the consideration in the form of the Relinquished Property. Therefore, a resulting trust should arise in favor of the Exchanger the party providing the consideration. Constructive Trust And Its Common Applications A constructive trust is an equitable remedy imposed by the court to prevent an unjust enrichment of a party holding property. Imposition of the trust compels the party wrongfully holding the property to convey it to its rightful owner. See 76 Am. Jur. 2d Trusts 168 (2005). Constructive trusts differ from resulting trusts in that creation of the former does not depend on the intentions of the parties. Restatement First of Restitution 160 (1937). Courts use constructive trusts to force the conveyance of property when the property was obtained by fraud, duress, breach of fiduciary duty, etc. However, the remedy is also available when the property was obtained innocently but when it would be inequitable to allow title to remain with the current holder. See 76 Am. Jur. 2d Trusts 169 (2005). A constructive trust could be applied when the exchanger misrepresented how the funds would be held or how the funds would be used when held by the QI. Alternatively, even in the absence of a misrepresentation, a constructive trust could be applied when the court determined it would be inequitable to allow the QI to continue holding title to the property. Conduit Theory And Its Common Applications In any situation where a debtor was intended to be a mere conduit of the property in its possession and was never intended to have the beneficial interest, section 541(d) excludes that property from the estate. Accordingly, section 541(d) does not apply only to property held in trust pursuant to state law. In re LAN Tamers, Inc., 329 F.3d 204 (lst Cir.), cert. denied, 540 U.S (2003); In re West Central Housing Development Organization, 338 B.R. 482 (Bankr. D. Colo. 2005). Government programs often use private entities to disburse funds earmarked for the beneficiaries. If the private beneficiary files for bankruptcy while holding these funds, courts have held that such beneficiary is merely a conduit for the funds with no equitable interest in them. Because the QI holds the Exchange Funds for the limited purpose of purchasing the Replacement Property, it has been argued that the QI is a mere conduit with respect to the funds. Courts Treatment of section 1031 Exchanges in Bankruptcy In In re San Diego Realty Exchange, Inc., 132 B.R. 424 (Bankr. S.D. Cal. 1991), which predates the 1991 safe harbor regulations, Exchanger entered into an agreement with the debtor to serve as an accommodator for his section 1031 exchange. Exchanger transferred two parcels of Relinquished Property to debtor, which immediately transferred them to the purchaser. The debtor held the Exchange Funds in an account

7 Like Kind Exchanges Under The Tax And Bankruptcy Codes 49 commingled with proceeds from other accounts as well as the debtor s operating funds. Exchanger identified two Replacement Properties. Both parcels were transferred from the seller to the debtor, which immediately transferred them to the Exchanger. However, the second parcel was transferred to the Exchanger within 90 days of the filing of an involuntary Chapter 7 bankruptcy petition against the debtor. The trustee filed an action to recover the transfer of the second Replacement Property as a voidable preference pursuant to 11 U.S.C The court rejected the Exchanger s argument that the Replacement Property was never property of the bankruptcy estate because it was held in a resulting trust. Because a resulting trust arises in favor of a party who pays consideration and because the purchase price here was paid out of a commingled fund including the debtor s operating fund, the Exchanger could not prove that his funds were used to purchase the Replacement Property. Any resulting trust would arise for the benefit of the debtor s customers generally. The Exchanger s inability to identify his funds in the commingled account precluded finding a constructive trust as well. Exchanged Titles: Continued Equitable Interest In Relinquished Property In In re Exchanged Titles, Inc., 159 B.R. 303 (Bankr. C.D. Cal. 1993), the Exchanger retained the debtor to act as QI in a reverse exchange whereby Exchanger deposited cash to allow the debtor to purchase the Replacement Property. After the Replacement Property was transferred to the debtor, the Exchanger transferred the Relinquished Property to the debtor while the debtor transferred the Replacement Property to the Exchanger. Before the debtor could transfer the Relinquished Property to a third party, the debtor filed Chapter 7. Exchanger filed a claim in the bankruptcy court seeking return of the Relinquished Property, claiming that the debtor held only bare legal title. In holding that the Exchanger retained an equitable interest in the Relinquished Property, the court held that section 1031 does not require that the Exchanger transfer his equitable interest. Further, the testimony of the Exchanger, that he always intended to sell it to a third party, that he paid all financial obligations relating to it, collected rents on it, etc, suggested a continued equitable interest in the Relinquished Property. Because the trustee was on constructive notice of the Exchanger s interest, he could not use section 544(a)(3), which grants the trustee the status of a bona fide purchaser as of the petition date, to cut off the Exchanger s interest. Sale Guaranty Corp.: Resulting And Express Trusts Foil Bankruptcy Trustee In In re Sale Guaranty Corp., 220 B.R. 660 (B.A.P. 9th Cir. 1998),aff d, 199 F.3d 1375 (9th Cir. 2000), the Debtor acted as an accommodator for the section 1031 exchanges of three Exchangers. Two Exchangers were attempting reverse exchanges in which the debtor held title to the Relinquished Property on its petition date. One Exchanger attempted a typical exchange in which the debtor held the Exchange Funds as of its petition date. Applying California law, the bankruptcy court held that the debtor held the Relinquished Properties in the reverse exchanges in a resulting trust for the benefit of the Exchangers and held the Exchange Funds in the typical exchange in an express trust for the benefit of the Exchanger. In neither case could the trustee use section 544 to avoid these interests. On appeal the Bankruptcy Appellate Panel affirmed. In both cases the court looked to the marketing materials as evidence of the intent of the parties to create a trust. Nation-Wide Exchange Services: Exchange Funds Remain In Estate, But Replacement Property Does Not In In re Nation-Wide Exchange Services, Inc., 291 B.R. 131 (Bankr. D. Minn. 2003), the Exchanger

8 50 The Practical Tax Lawyer Winter 2011 retained debtor to act as QI under an agreement whereby Exchanger agreed to sell the Relinquished Property to a third party and assigned its interest to the cash proceeds to the debtor. The debtor purchased the undeveloped Replacement Property and was directed to use the excess Exchange Proceeds to make payments directly to the Exchanger s builder, which was improving the Replacement Property. Upon completion of the construction, the debtor was to transfer the improved Replacement Property to the Exchanger. Within 90 days of the debtor s bankruptcy filing, the debtor disbursed $306,427 to the Exchanger s builder. As of the petition date, the debtor still had title to the Replacement Property. The trustee filed suit to recover the payments to the builder pursuant to section 547(b). The Exchanger requested that the court compel the trustee to turn over the Replacement Property. The Exchanger first argued that the trustee could not invoke section 547(b) because the Exchange Funds were not property of the estate. The court rejected that argument on three grounds: 1) for the debtor to have been empowered to direct payments of funds owned by a third party, an agency relationship is required, which the parties agreement specifically rejected; 2) the lack of any direction on the use of the funds in the agreement combined with the substantial control exercised by the debtor meant the funds were owned by the debtor; and 3) even if the Exchange Funds initially were the Exchanger s property, the debtor s actual handing of them, including using them for its own purpose, converted the funds. The Exchanger next argued that it was not a creditor and did not hold an antecedent debt because no money was owed until the contractor actually performed work. The court rejected this argument because the Bankruptcy Code s definition of claim included contingent and unmatured claims. In addition to the Exchanger s attack on the trustee s prima facie case, the Exchanger raised two statutory affirmative defenses. First, the Exchanger argued that the contractor provided contemporaneous new value in the form of lien waivers relating to the improvements. The court rejected this because the lien waivers did not result in any substitute value to the estate which it could control or direct; the debtor was always obligated to convey the improved Replacement Property back to the Exchanger. The court also rejected the Exchanger s ordinary course of business defense, noting that a section 1031 exchange of a significant capital asset was not the Exchanger s business and that this was a one-time contractual relationship, thereby precluding any historical comparison. Although the court granted the trustee judgment on her preference suit, it ordered her to convey the Replacement Property to the Exchanger, noting that the Exchanger had performed its duties under the agreement and the trustee could not reject it. LandAmerica 1031 Exchange Services: Exchange Funds Presumed Part Of Estate In In re LandAmerica 1031 Exchange Services, Inc., 412 B.R. 800 (Bankr. E.D. Va. 2009); 2009 WL (Bankr. E.D. Va. May 7, 2009), Land- America Financial Group, Inc. ( LFG ), the nation s third largest title insurer and its wholly owned subsidiary, LandAmerica 1031 Exchange Services, Inc. ( LES ) filed a Chapter 11 petition in the Bankruptcy Court for the Eastern District of Virginia on November 26, As of the petition date, LES had approximately 450 uncompleted section 1031 exchanges in which it served as a QI. Approximately 50 exchanges involved the use of segregated accounts whereby Exchange Funds were held in separate bank accounts associated with the Exchanger s name. These Exchangers had claims of approximately $138 million. The remaining exchanges involved the Exchange Funds being placed into a commingled account. The claims of these commingled Exchangers totaled approximately $192 million. Although LES paid a nominal interest rate to customers, it invested the funds in the commingled account in various ways to maximize in-

9 Like Kind Exchanges Under The Tax And Bankruptcy Codes 51 come on the Exchange Funds for itself. Among the investments purchased with the Exchange Funds were auction rate securities, the market for which collapsed in February 2008, essentially freezing approximately $200 million. Over the next several months LES continued to operate. Continued operations were made possible, in part, due to a transfer of $65 million from LFG to LES. As new exchanges declined because of the overall decline in the real estate market, LES s cash diminished to the point where it ceased completing exchanges, followed by bankruptcy days later. Within weeks of the petition date, over 85 Exchangers filed adversary proceedings under various theories seeking recovery of their respective Exchange Funds. The court stayed all adversary proceedings except for five test cases representing different types of exchange relationships used by LES, which were heard on an expedited basis. Two commingled cases with slight variations in the agreements were selected. Two segregated cases, one with an agreement containing an escrow clause and another without one were chosen. Finally, one case in which LES held a promissory note as well cash as Exchange Funds was chosen. The test case litigation was bifurcated into two phases with the first focused on the ownership of the funds and the second focused on fraud remedies and damages, including imposition of a constructive trust. After discovery was completed all parties filed cross motions for summary judgment except for the test case plaintiff with the escrow agreement, which settled its dispute at the completion of discovery. Holdings The bankruptcy court issued two opinions, one for the segregated test case and one for the remaining cases. The court began both opinions with the presumption that the Exchange Funds were property of the estate because they were transferred to LES from the closing of the sale of the Relinquished Property. The Exchange Funds were wired directly to LES where they remained through the petition date. The Exchangers had no ability to withdraw them. Accordingly, the Exchanger must rebut this presumption. Applying Virginia law, the court rejected the argument that there was an express trust. Not only was there no language one would expect to find such as trust, beneficiary, etc., the language used in the agreements affirmatively suggested that there was no trust. The agreements used the phrase LES shall have sole and exclusive possession, dominion, control, and use of all Exchange Funds. It went on to state that the Exchanger had no right title or interest in or to the Exchange Funds. Finally, the agreements limited the duties of LES to those specifically set forth therein. Accordingly, no fiduciary duty could be implied. Further evidence that the parties did not establish a trust was that they did not use the qualified intermediary/trust safe harbor. The court also rejected the segregated test case plaintiff s argument, that the use of segregated accounts associated with the Exchanger s name was indicative of an intention to create a trust. The court held that segregation only made the requisite tracing for the establishment of a trust easier; it did not alter the intent element required of a trust. Further complicating the commingled test case plaintiffs position was the inability of the Exchangers to trace their funds, an additional requirement even if a trust is found to have been established. The court also rejected any argument that a resulting trust should be imposed because the agreements evidenced an intention not to impose a trust. In light of the clear, unambiguous language of the agreements, the court could not look to the surrounding circumstances. Finally, the court rejected the conduit theory, noting that the theory had only been applied when funding from a government program was specifically earmarked.

10 52 The Practical Tax Lawyer Winter 2011 Real Estate Exchange Services: No Express Or Constructive Trust In In re Real Estate Exchange Services, Inc., 2009 Bankr. LEXIS 3731 (Bankr. N.D. Ga. Oct. 9, 2009), two Exchangers who had engaged debtor to act as a QI requested the court to order the Chapter 11 trustee to turn over Exchange Funds held in the debtor s bank account, arguing that they were held in either an express, resulting, or constructive trust. The Exchange Funds were held in an account commingled with funds of other Exchangers. Applying Georgia law, the court looked to the language of the exchange agreement, which included a provision that the Exchanger shall convey all of Exchanger s rights, but not obligations, in Relinquished Property to the [QI], in holding that there was no express trust for the benefit of the individual exchangers. The court did leave open the possibility that the entirety of the commingled account might be held in an express trust for the benefit of all exchange customers. Because the debtor did not take title to property using funds supplied by the Exchangers, the court rejected the use of a resulting trust. Similarly, the court found no grounds to impose a constructive trust where the debtor did not commingle Exchange Funds with its own funds and where the debtor abided by the terms of the exchange agreement. Statutory/Regulatory Modifications The IRS has promulgated a procedure whereby an Exchanger who is unable to complete an exchange because the QI defaults on its obligation to acquire the Replacement Property is treated as not being in receipt of the proceeds if the Exchanger reports gain in accordance with a gross profit ratio method defined therein. Washington Rev. Code Chapter (Enacted 2009) Under Washington Rev. Code Chapter19.310: 1. The Exchange facilitator cannot sue to collect its fee if it is not in compliance with the regulations. 2. The Exchange facilitator must notify customers of a change in control (transfer of more than 50 percent of assets or ownership). 3. The Exchange facilitator must maintain a bond or post some other form of liquid security on deposit with a financial institution in the amount of at least $1 million. Alternatively, the exchange facilitator must use a qualified escrow or qualified trust. Customers damaged by fraudulent or dishonest acts of the facilitator may make a claim on the bond or alternate security. 4. The Exchange facilitator must maintain an errors and omissions insurance policy in the amount of at least $250,000 or deposit some form of liquid security in that amount with a financial institution. Customers damaged by unintentional errors or omissions of the facilitator may make a claim on the insurance policy or the alternate security. 5. The Exchange facilitator must act as a custodian in such a manner so as to preserve liquidity and principal. If Exchange Funds are invested, such investments must meet the prudent investor standard. Violation of the standard includes commingling the Exchange Funds with the facilitator s operating accounts among other acts. 6. Exchange Funds are not subject to execution or attachment on any claim against the facilitator. 7. Each office operated by a facilitator must be managed by an attorney, C.P.A. or a person who has passed a test regarding exchange facilitation. 8. All customer accounts of at least $500,000 must be held in separately identifiable accounts and the customer must receive all interest. Customer accounts containing less than $500,000 may be held in pooled interest-bearing accounts if the customer consents in writing. 9. Exchange facilitators are required to report various statistics regarding business activities.

11 Like Kind Exchanges Under The Tax And Bankruptcy Codes 53 Nevada Rev. Stat. Chapter 645G (Enacted 2007) Under Nevada Rev. Stat. Chapter 645G: 1. The Exchange facilitator must be licensed by the Division of Financial Institutions of the Department of Business and Industry. 2. The Exchange facilitator must be managed by an attorney or C.P.A. or a certified exchange specialist as certified by the Federation of Exchange Accommodators or someone with three years experience as determined by the Division of Financial Institutions. 3. Each licensee is a fiduciary of the property received from the customer and all investments of such property must meet the reasonable standards applicable to persons acting as fiduciaries in Nevada. 4. Exchange Funds cannot be withdrawn without the written approval of the licensee and the customer. 5. Insurance and bonding requirements are similar to those required under Washington law, except that depositing Exchange Funds into a qualified escrow or qualified trust is not an alternative to the bonding/security requirement. 6. Exchange Funds must be separated from the licensee s money and kept in an insured account unless another financial institution is designated in the contract. Exchange Funds must be designated as trust funds, escrow accounts, or in some other similar manner. 7. Exchange Funds are not subject to attachment or execution by claims of the licensee. California Fin. Code et seq. (Enacted 2008) California Fin. Code et seq. requires that: 1. The Exchange facilitator must notify customers of a change in control (transfer of more than 50 percent of assets or ownership). 2. Insurance and bonding requirements similar to those required under Washington law must be met. Note: qualified trust/escrow is an acceptable alternative to the bonding requirement. 3. The Exchange facilitator must act as a custodian in such a manner so as to preserve liquidity and principal. If Exchange Funds are invested, such investments must meet the prudent investor standard. Violation of the standard includes commingling the Exchange Funds with the facilitator s operating accounts among other acts. Colorado Rev. Stat et seq. (Enacted 2009) Under Colorado Rev. Stat : 1. The Exchange facilitator must notify customers of a change in control (transfer of more than 50 percent of assets or ownership). 2. Insurance and bonding requirements are similar to those required under Washington law. Note: qualified trust/escrow is an acceptable alternative to the bonding requirement. 3. The Exchange facilitator must act as a custodian with fiduciary duties with respect to Exchange Fund. 4. Exchange Funds are not subject to attachment or execution by claims of the facilitator. 5. Exchange Funds must be kept separate from the facilitator s and, in the case of accounts of at least $250,000, must provide for the customer s authorization before withdrawal. 6. Exchange Funds must be invested so as to meet the prudent investor standard. Virginia Code et seq. (Enacted 2010) Under Virginia Code et seq.: 1. The Exchange facilitator must notify customers of a change in control (transfer of more than 50 percent of assets or ownership).

12 54 The Practical Tax Lawyer Winter The Exchange facilitator must deposit Exchange Funds into a separately identified account providing for written authorization from the customer before withdrawals. Alternatively, the funds may be deposited into a qualified escrow/trust. 3. Exchange Funds must be deposited into a financial institution and interest must accrue to the customer unless the customer gives written consent for the Exchange Funds to be invested in an investment of the customer s choosing. 4. Exchange facilitators must maintain an errors and omissions insurance policy in the amount of at least $250,000 or deposit cash or an irrevocable letter of credit in that amount. 5. Exchange facilitators hold all property on behalf of the customer and must not commingle it with their own funds and may not lend Exchange Funds to affiliated entities. Exchange Funds are not subject to execution or attachment by claims of the facilitator.