Under Section 1031 of the Internal Revenue Code, a taxpayer does not recognize gain or loss on the exchange of like-kind property. Before 1984, the Code did not specifically address so-called deferred exchanges - exchanges in which the taxpayer relinquished property and some time later received the replacement property - although at least one leading case did. The 1984 rules require that the taxpayer identify the replacement property within 45 days after the disposition and close on the replacement property and close within 180 days after the disposition. Because of the difficulties in arranging for the buyer to obtain replacement property to exchange with the taxpayer, in practice exchanging parties would use a third-party intermediary. In 1991, the IRS adopted Regulations creating safe harbors for, among other things, using a third party intermediary. Thus the "qualified intermediary," or QI was born.

The Regulations adopt the legal fiction that the exchangor taxpayer is exchanging property with the QI, not with the ultimate purchaser of the relinquished property or with the seller of the replacement property. Typically, the taxpayer assigns the purchase agreement to the QI, who the Regulations deem to be the party that sells the property to the buyer in exchange for cash or other consideration. Most important, the taxpayer cannot receive, actually or constructively, the consideration for the property. The Regulations generally treat the cash held by the QI as a loan from the taxpayer. The QI holds the consideration in an account generally controlled by the QI, and then uses the cash to purchase the replacement property, which it then delivers to the taxpayer. All this must be accomplished within the 180-day window. In some cases, the QI places the cash in a commingled account; in others, in a segregated account. Deferred exchanges have been very popular. They allow the taxpayer to defer both capital gains (generally taxed at 15% under current law) as well as depreciation recapture (generally taxed at 25% under current law).

Bankruptcy Considerations in Like-Kind Exchange Transactions

Accepted practice for a QI prior to 2009 has been to use a segregated account to hold exchange funds. This is the type of account at issue in Millard Refrigerated Services Group v. LandAmerica 1031 Exchanges Services, an adversarial proceeding from the Bankruptcy Court for the Eastern District of Virginia related to the LandAmerica Financial Group bankruptcy. LandAmerica 1031 Exchanges Services ("LES") acted as a QI in numerous deferred like-kind exchanges intended to qualify under Code Section 1031. When LES entered bankruptcy, it was holding funds for about 450 uncompleted exchanges. LES held most funds in commingled accounts; but it held about cash from about 50 exchanges in segregated accounts. The Bankruptcy Court held that the segregated account was the property of the bankruptcy estate, not the property of the exchangor, rejecting the exchangor's arguments that the QI acted as a trustee or in some other fiduciary capacity for it. Under Millard, not only could a bankruptcy filing delay the completion of the exchange beyond the statutory 180-day period, but also the funds may never become available.

In addition to permitting QIs, the Treasury Regulations provide three other safe harbors that avoid constructive receipt: using a security or guarantee arrangement, an escrow arrangement or a trust. If the conditions of the safe harbors are satisfied, then the exchangor is not in constructive receipt of the proceeds of the sale of the property. Use of these safe harbors, however, does not address whether an exchangor can ensure that the money from the sale of the relinquished property is not subject to being included in a bankrupt debtor's bankruptcy estate. The Regulations still require that, during the exchange period, the exchangor cannot have access to the money. Using a guarantee arrangement does not obviate the risk of the guarantor's bankruptcy, so this would not be an optimal alternative. Using carefully crafted trust or escrow arrangements, however, may provide more protection.

The Law Remains Unsettled

The exchange party in Millard Refrigerated Services Group has filed a notice of appeal; the final chapter many not have been written yet in this case. Nonetheless, given the recent trial court decision, exchangors, particularly in the current economic climate, should be very cautious when entering into deferred exchange arrangements.