Decoding the 1031 Exchange

The 1031 Exchange is a structured property sale whereby a taxpayer (including not only individuals, but partnerships and corporations) involved may defer the payment of a capital gains tax by exchanging one parcel of property for another equivalent or like-kind parcel. In undertaking the transaction, it must be set up pursuant to the rules laid down in United States Income Tax Code section 1031, which states:

“No gain or loss shall be recognized on the exchange of property
held for productive use in a trade or business or for investment
if such property is exchanged solely for property of like kind
which is to be held either for productive use in a trade or business
or for investment.”

In plain language, this means that owners of investment property may enter into a deferred multi-party exchanges whereby they sell their investment property and defer capital gains taxes by exchanging the proceeds, through a facilitator or qualified intermediary (the “exchanger”) for an investment in another like-kind property or group of like-kind properties. It is critical that the seller places all sale proceeds into a special trust fund account designated for this purpose.

There are several wrinkles to such an exchange. For example, ordinarily, the exchange is simultaneous. However, if a “qualified intermediary” holds one of the parcels in trust, the parties involved in the exchange can delay the transfer. In this context, the parties can get in trouble if they fail to pay attention to the meaning of the term “qualified intermediary.”

To avoid additional fees, there are times when the attorney for the parties may seek to act as the “qualified intermediary” with respect to a proposed Section 1031 Exchange. In doing so, the attorney may set up a separate company to act as the facilitator or qualified intermediary for the 1031 exchange.

Normally, a qualified intermediary is bound by something known as the independent-third-party rule, which rules appears based on the fear that an agent as intermediary could destroy the exchange nature of the transfer. In short, the use of an agent would conceivably permit a party to conduct an exchange with himself. Cf. Coupe v. Commissioner Internal Revenue, 52 Tax Court 394 (1969). Recognizing this rationale, courts have accepted the straw man approach whereby an attorney creates a corporation as an acceptable means of affecting such a transfer. Biggs v. Commissioner Internal Revenue, 632 F.2d 1171 (1980).

Thus, in Biggs, supra, the Court found acceptable a transaction whereby at an individual’s behest a corporation owned and controlled by that individual’s counsel accepted title to realty. The Court held that the attorney-created corporation merely accepted title to the property in order to facilitate the exchange. The attorney’s status as an agent of the seller did not affect the transaction’s status as a qualified exchange.

In State of Washington v. Grimes, 110 Wash.App. 272, 111 Wash.App. 544, 40 P.3d 694, 46 P.3d 801 (2002), the Court affirmed an accommodator’s conviction for theft of property under his control pursuant to Section 1031. In Grimes, the exchanger (1) failed to hold the funds in trust for the purpose of the transactions; (2) failed to deposit the funds in separate escrow accounts; and (3) used the funds for his own benefit. The Court held that United States Tax Code section 1031 does not alter the actual nature of the transaction. Moreover, the Court found that the accommodator’s assumption of title was solely for the purpose of the exchange.

Another wrinkle concerns the kind of property exchanged. Normally, a 1031 exchange involves the transfer of real property. Yet, in certain instances, the parties may seek to exchange stock or other securities. At this point, you begin to see the real complexity of a 1031 property exchange. This is a sophisticated transaction.

In such sophisticated multi-party transactions, you need independent counsel. When these deals go south, the fallout can be spectacular. The Los Angeles County Superior Court system is one of the busiest judicial systems in the United States. A year or so ago, the longest running active civil case on its calendar involved multi-party 1031 exchange that fell apart. We speak of litigation that did or has dragged on for more than a decade. Done correctly, United States Income Tax Code section 1031 is an excellent means to defer or avoid unwanted taxes. Done wrong, it can be a nightmare.