• Risks Associated with Section 1031 Tax Exchanges
  • January 9, 2009
  • Law Firm: LeClairRyan - Richmond Office
  • In a 1031 exchange, property owners are allowed to defer capital-gain taxes on the sale of investment properties. The property owner must purchase a property similar to the one sold within 180 days and the sale proceeds must be held by a neutral third party, known as a qualified intermediary (“QI”).

    Over the past few months, our lawyers have seen significant problems arise in a section 1031 exchange from the QI’s deposit, holding, and/or use of the exchange funds. These problems have involved hundreds of millions of dollars and many of the property owners participating in the 1031 exchanges have had disastrous results. Our team at LeClairRyan has identified two areas of particular concern. We urge our clients and friends with pending 1031 exchanges to evaluate their risk exposure.

    1. Depositing your sale proceeds into a commingled account. QIs can hold client exchange accounts in one of two ways: in a commingled account, or in a segregated account. Problems have arisen when the QI deposits proceeds of all clients’ exchanges in one single account, a commingled account. QIs are likely to use a commingled account unless you insist otherwise. Commingled accounts are a large source of revenue for QIs. By investing a larger amount of money, the QI is able to obtain a greater return. However, this practice tends to lead the QI to make risky investments with the commingled account in order to maximize their return. The best practice is for the QI to hold each client’s money in separate accounts.
    2. Investing your sale proceeds in an illiquid market. QIs promise to pay clients a small return, typically 0.5% or 1.0%, in exchange for holding the money during the exchange period. To fulfill this promise, QIs typically invest the sale proceeds into higher-yielding auction-rate securities. In February 2008, the fallout from the housing-market slump caused the auction-rate security market to collapse. As a result, QIs are now holding investments in an illiquid market and many are not able to meet their client’s withdrawal demands.

    In order to ensure your 1031 exchange funds are available when you need them, we encourage you to review the contract you entered into with the QI to ensure that your sale proceeds are being held in a separate account and to determine how your funds are being invested.