New Protections for 1031 Exchange Funds

This is the 3rd in a series of brief articles that Moye White is sending to its real estate-oriented clients and friends to provide practical advice about the opportunities and challenges presented by today's economy.

Governor Ritter recently signed legislation to protect real estate investors attempting a qualified tax deferred exchange under Code Section 1031 of the Internal Revenue Code (“1031 exchanges”).

Under existing 1031 exchange requirements, an investor cannot receive any proceeds from the sale of property without risking the tax-deferred status of the exchange. To avoid this risk during a pending 1031 exchange, an investor’s sale proceeds are deposited with a qualified intermediary who will hold the proceeds and complete the 1031 exchange on behalf of the investor. Unfortunately, recent headlines concerning 1031 exchanges have been filled with examples of fraud and mismanagement by qualified intermediaries resulting in significant losses to investors.

Examples of fraud and mismanagement by qualified intermediaries include the 2007 theft of more than $1.5 million of 1031 exchange funds by an attorney who was acting in the capacity of a qualified intermediary. In 2007, the loss of approximately $132 million in 1031 exchange funds was orchestrated by Edward Okun as the principal of a holding company that acquired other qualified intermediary companies. Additionally, in 2008, a large, nationwide qualified intermediary company invested over $400 million of 1031 exchange funds in securities that became illiquid in the recent financial collapse. As a result, the company filed bankruptcy. While some exchangers demand that their qualified intermediaries establish segregated accounts to hold their money, even this step may not provide the intended protections; a bankruptcy court recently ruled that funds held in a segregated account are part of the bankruptcy estate and may be used to pay the company’s creditors. Investors are advised to carefully read and negotiate exchange agreements with qualified intermediaries before the transfer of sale proceeds.

The new state legislation will provide Colorado real estate investors with some recourse to protect funds put at risk in their 1031 exchanges. Highlights of the protections implemented by the new legislation include the following:

  • Investment of Proceeds. The qualified intermediary must provide written notification informing the investor of the manner in which the 1031 exchange funds will be invested or deposited. In the past, many investors had no knowledge of where their funds were invested and were surprised to learn the funds were not held in safe, liquid investments (e.g., a segregated FDIC-insured account).
  • No Commingling of Funds. The new legislation prohibits the commingling of exchange funds of multiple investors. It is critical that an investor’s exchange funds be held in a segregated account and not commingled with other operating or investment funds. A segregated account can assist in the “tracing” of funds withdrawn from the account, which provides a greater chance of recovering funds. In addition, the exchange agreement providing for the segregated account should be carefully worded to further protect the investor’s interests.
  • Withdrawal Authorization. Any withdrawal of 1031 exchange funds exceeding $250,000 will require the authorization of both the qualified intermediary and the investor. With this requirement, investors will have more control over the withdrawal of 1031 exchange funds, which will limit the risk of theft. While this could be interpreted by the IRS as an investor/taxpayer exerting control over the 1031 exchange funds, it is unclear whether the IRS will advance this argument.
  • Change in Control. A qualified intermediary is required to notify the investor of any change of ownership of a qualified intermediary company within two business days after the effective date of the change. This requirement will permit investors to investigate the ownership and identity of the parties that will have control over the 1031 exchange funds.
  • Insurance. A qualified intermediary is required to maintain a fidelity bond in the amount of $1,000,000 and errors and omission insurance of $250,000. By requiring minimum amounts of insurance, investors will have a better chance of recovering some of the funds that are lost due to the fraud or mismanagement by a qualified intermediary. Investors are cautioned to read carefully the bond and any certificates which evidence this insurance.

For more information contact: Bo Anderson, John Benitez, Co-Chair, Real Estate Group, or Ted White, Chair, Transaction Section at (303) 292-2900.

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Moye White LLP has prepared this bulletin to provide general information; however this bulletin does not provide legal advice and does not create an attorney-client relationship between the reader and Moye White. No legal or business decision should be based solely on the content of this bulletin.