Thursday, July 9, 2009

How to protect your money in a 1031 tax free exchage

With the recent collapse of some 1031 exchange companies, we checked in with a couple of our contacts for information and advice we might pass along. We asked lawyers Toija J. Beutler of Investment Property Exchanges Services (IPX) exchange and Ron Shellan of Miller Nash LLP what information they had regarding the best way to protect your money in a 1031 exchange. Here is what they had to say:

Collapse of Exchange Companies: Protecting Your Investment
Ronald Shellan, Attorney at Law, Miller Nash LLP

In the Pacific Northwest, a number of tax-free exchange accommodation corporations have collapsed into bankruptcy. These collapses can be financially devastating for taxpayers who have deposited their funds with these companies in order to take advantage of the tax-free exchange provisions of the Internal Revenue Code.

In late November, LandAmerica Financial Group Inc. filed for Chapter 11 protection. Its tax-free exchange accommodator unit had invested its funds in auction-rate securities. The credit crunch rendered these investments illiquid, and the company was unable to timely pay its obligations to taxpayers to use the funds to acquire replacement property for their exchanges.

In December, Bend's Summit 1031 Exchange also collapsed and filed for Chapter 11 bankruptcy. Reports indicated that it owed more than $27 million to clients. In this case, some of the funds had been invested in real estate transactions, violating promises to invest the funds in short-term, liquid investments.

Taxpayers can sell real estate on a tax-free basis if the funds are reinvested in other like-kind real estate. The IRS allows the sale proceeds to be held by an accommodator or "qualified intermediary" for up to 180 days while the replacement property is identified and acquired. In most states, accommodators are not regulated or insured by the state. Thus, like any business, they can experience economic reversals. If an accommodator files for bankruptcy, however, the taxpayer may lose some or all funds. Further, what funds are available are often tied up in litigation for many months, preventing the exchange from being completed within the 180-day period required by tax rules governing tax-free exchanges. If the funds cannot be used within the 180-day period to acquire replacement property, the exchange is fully taxable.

What can taxpayers do to protect themselves from a bankruptcy or insolvency of a tax-free exchange accommodator? There is a solution that is easy and practical. IRS regulations allow the use of Qualified Trusts or Qualified Escrows. When the transaction closes, the funds are held by a third party—normally a bank in either a trust or an escrow relationship. If funds are so held, the bankruptcy or insolvency of the accommodator will not affect the funds held by the third-party bank. Many accommodators have a standard form for either a Qualified Trust or Qualified Escrow and relationships with banks or escrow companies. Lawyers who practice in this area often also have prepared forms that can be used to facilitate a risk-free exchange. Both trusts and escrow companies have strict capital requirements that make it more likely that they will be able to meet their obligations.

Taxpayers should also take two additional steps to protect themselves:
  1. The escrow instructions to the escrow company closing the real estate transaction should provide that the funds go directly to the trustee or escrow agent and that the Qualified Trust or Qualified Escrow agreement be signed as part of the closing. Second, if the exchange funds exceed the FDIC insurance limits (either $100,000 or $250,000, depending on the type of account and the date), taxpayers should take at least three additional considerations into account to protect themselves. One consideration is obtaining additional FDIC insurance. This is available at most banks under the Transaction Account Guaranty Program available through the end of 2009 (which is expected to be extended). The extra insurance comes at a cost, though, because no interest is paid on the accounts and most accommodators will charge a higher fee.
  2. A second approach is to deposit the funds in a bank that uses the CDARS Program. This program protects depositors by providing FDIC insurance for the entire deposit. This is accomplished by using a computer-driven program to deposit the funds in multiple institutions so that no institution holds more than the amount that would be insured by the FDIC. The downside is that the funds are not immediately available because the funds are in certificate of deposit accounts. A final alternative is to find a bank that is financially strong enough so that the FDIC insurance limits are not an issue.
There is nothing like a worldwide financial meltdown to refocus attention on reducing risk. The risk in depositing taxpayer funds with an accommodator can largely be eliminated by using either a Qualified Trust or Qualified Escrow, issuing escrow instructions to make sure the funds are directly deposited in a bank, and considering whether additional protection for amounts in excess of applicable FDIC limits is needed.

Ron Shellan is a partner at Miller Nash. He practices tax law and real estate law with a focus including tax-free exchanges, affordable housing and low-income housing tax credits, historic tax credits, corporate and business acquisitions, and tax law. Ron is a certified CPA and has twice been a director of the Oregon Society of CPAs. Ron can be reached at 503-205-2541 or by e-mail at

Common Questions From Anxious Would-be-Exchangers
Toija J. Beutler, Attorney/Manager, IPX1031

Q. How do I find an exchange company?
A. Ask your commercial broker, attorney or accountant for names. They have probably had experience with several companies and can direct you to those with long histories and solid reputations.

Q. My broker gave me a couple of names. Does it really matter which company I select? Aren’t they all the same?
A. No, they are not all the same as we learned from several recent failures. Just as you conduct due diligence before buying a property, it is more important than ever that you conduct due diligence before selecting an exchange company.

Q. What questions should I ask?
A. The most important shopping feature is security. The exchange company will be holding your sale proceeds and, unlike banks, exchange companies have historically been unregulated. While this is beginning to change Exchangers must always look out for themselves. Just a few of the comparison points when shopping exchange companies:
  • How long has the company been in business?
  • Do they have an attorney, CPA or Certified Exchange Specialist on staff?
  • Do they have a fidelity bond and, if so, how much?
  • Do they have an errors and omissions policy and, if so, how much?
  • Do they have a guaranty from a third party?
  • Where do they invest the exchange funds and how?
  • How many signatures are required to move the funds?
  • Are the accounts audited by independent auditors?
Q. How do I know my money is safe?
A. Your best approach is to select a solid exchange company in order to minimize any risk. Make sure the exchange company has selected a strong bank. Perhaps the bank can be named in the exchange agreement. Ask if the bank can send statements directly to you so you can track the funds on a monthly basis.

Q. I don’t see pricing on the list. Isn’t that important?
A. There is little pricing difference between the companies, perhaps a couple hundred dollars one way or the other. The real difference is in the security offered by each company.

Q. I am selling in Washington and buying in Oregon. Can companies work across state lines?
A. Yes, companies work across state lines all the time. However, ask if the company is in compliance with each state’s applicable regulation. For example, Washington’s new law requires companies handling a sale in Washington to have a minimum level of bonding and errors and omissions coverage. They also require that an attorney, CPA or “person who has passed a test specific to exchange facilitation” be directly managing the business. Not all companies currently meet this requirement.

Q. Is there anything else I should be looking for?
A. Yes, staff expertise. Exchange companies prepare exchange documentation and hold your sale proceeds. And while that work is critical to your exchange, make sure they can also answer your questions about the basic rules but especially about anything out of the ordinary. You still need your own attorney and accountant advising you but experienced exchange companies can be a great help when issues arise – and 75% of all exchanges face issues and challenges.

Toija J. Beutler is Attorney/Regional Manager for Investment Property Exchanges Services, Inc. (IPX1031). She can be reached by phone at 888.310.1031 or by e-mail at