Could a Qualified Intermediary Go Bankrupt and Tie Up Money Designated for a Section 1031 Exchange?

In the normal course of events, the sale of a capital assets that results in a gain to the seller is a taxable event. As such, a taxpayer who realizes a gain from the sale of a capital asset will owe capital gains tax on the realized gain. One way to avoid, at least for a time, the payment of capital gains taxes is to enter into a Section 1031 Exchange in lieu of a traditional sale. If a transaction qualifies for Section 1031 treatment, any capital gains taxes that would normally be due on the gain are deferred. Among the many rules for entering into a Section 1031 Exchange is that you use a “Qualified Intermediary” to facilitate the exchange. Could the Qualified Intermediary go bankrupt and tie up the money designated for a Section 1031 Exchange? Although this is a very complicated, and unsettled, area of the law, the bottom line answer to that question is “yes.”

Names after the location of the provisions in the Internal Revenue Code, a Section 1031 Exchange allows a taxpayer to “exchange” capital assets instead of engaging in a traditional sale and purchase of those assets. For a transaction to qualify for Section 1031 treatment, the following must all be true:

• The property must be held for productive use in a trade or business, or for investment.
• The property must be exchanged for “like-kind” property. A single family home cannot be exchanged for gold, for instance.
• The entire exchange must be completed within 180 days.
• A Qualified Intermediary, or QI, must be used to facilitate the exchange.

The QI is responsible for holding both title to involved property and funds used in the exchange for the duration of the 180 day period or until the exchange is completed. As a result, a QI could be “holding” millions of dollars of client funds at any given time. Funds are supposed to be held in escrow; however, the entire QI business is seriously lacking in regulations. As a result, clients are strongly urged to investigate a potential QI thoroughly and use caution when selecting a QI because it is possible for a QI to go bankrupt and leave clients’ money tied up in bankruptcy court for months, even years. More disconcerting is the fact that the client of a QI will likely be considered an unsecured creditor in the bankruptcy, meaning the client will not even be given priority when the bankruptcy Trustee distributes available assets to creditors of the debtor.

If you plan to enter into a Section 1031 Exchange it is imperative that you consult with an experienced Pennsylvania real estate attorney first to ensure that your interests are protected throughout the exchange. Contact the real estate law attorneys at Curley & Rothman, LLC by calling 610-834-8819 today to schedule your free consultation.