The Risk of 1031 Exchanges in Today's Financial Climate

LandAmerica Financial Group, Inc. and a subsidiary, LandAmerica 1031 Exchange are both in Chapter 11. Section 1031 of the Internal Revenue Code lets investors delay capital gains taxes on the proceeds from the sale of property if (1) the proceeds are reinvested in a new property within 6 months and (2) a third party (a "qualfied intermediary") holds the funds in between the sale and new purchase.

Holding funds as a qualified intermediary has been a very lucrative business. The third party serving as the intermediary charges a fee and pays minimal interests while it invests the funds in higher yield paper, such as auction-rate securities backed by federally insured student loans (one of the now frozen markets). In order to charge lower fees for one's services as the qualified intermediary, the funds being held would be aggregated into one large pot of money so as to more effectively seek out those higher yields on investments. Unfortunately, when the intermediary ends up in bankruptcy, how do you determine what funds belong to whom.

There are certain problems an investor faces when the intermediary holding the investor's funds goes bankrupt:
If the sale proceeds were not held in a segregated account by the intermediary, but instead comingled with all the other proceeds, the bankruptcy court will have a devil of a time figuring out who owns what with respect to the funds.
If an investor is running up on the 6 month deadline for reinvestment on the funds, the delays caused by the bankruptcy will likely blow that deadline and cause the investor to incur taxes on the sale.
Obviously such delay hinders an investor being able to close at all on the property identified for the purchase transaction.
If the assets purchased by the intermediary with the 1031 exchange money are sold for less than 100 cents on the dollar, how short will the investor be and when will that be determined?

Requiring that the proceeds be held in a segregated bank account is certainly a more prudent approach for an investor. Be prepared for higher fees being charged as a result since an intermediary will not realize the higher yields it can obtain from comingling into a large investment account. However, it is well worth it to better ensure that all the funds will be there when needed to close timely on a purchase.

At the risk of stating the obvious, checking out the financial soundness of the 1031 intermediary prior to selecting one is vital as well. In response to these recent events, First American has been emphasizing its financial stability in marketing its title and 1031 services. There are still financially sound 1031 exchange companies out there. An investor just needs to take the time to seek one out.


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William L. Exeter said...

The majority of Qualified Intermediaries do not invest in securities such as auction rate securities. The practice of investing in auction rate securities was only used by those who were a little too greedy in trying to increase their yield for profits.

Connie Carr said...

William Exeter's comment is a valid observation. Not all Qualified Intermediaries are the same. Many are more prudent in their practices than LandAmerica was. Investors contempating a 1031 exchange need to exercise caution and ask the right questions to ensure that they are using one of the more responsible Qualified Intermediaries.

Anonymous said...

William and Connie make good points, but the critical problem is still that Qualified Intermediaries are still unregulated in what they do with your money. It's nice to say that "the majority" of QIs are not doing this, but that means your still could be.

The only foolproof solution is to agree with your qualified intermediary up front on where your money is being invested. That's what we've implemented at my company, and I hope it is a trend that will catch on.