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The Bankruptcy StrategistLJN NewslettersNewsSections

Qualified Intermediary Bankruptcies

By Emil Hirsch and Thomas Lynch

When an IRS Code ' 1031 “qualified intermediary” files for bankruptcy, this triggers unique challenges to the constitutionality of the bankruptcy process, as well as to the boundaries of a bankruptcy court's equitable powers under Bankruptcy Code ' 105 and interpretations of state property law. Section 1031 of the U.S Tax Code allows taxpayers to avoid paying taxes on capital gains resulting from sales of real property through a type of “like-kind exchange.” To accomplish the exchange, the taxpayer must give a “qualified intermediary” (QI) constructive possession of the proceeds from the sale of real property, and direct the QI to apply those proceeds the purchase of a “replacement” within 180 days. Once the exchange is completed, the taxpayer is no longer required to pay any capital gain taxes on the proceeds. Often, the QI is given full legal dominion over the proceeds under an exchange agreement for period from the original sale until closing on the replacement property.

Ideally, 1031 exchanges provide a significant tax benefit while allowing the QI to make a profit on the 180-day private investment. However, when the investment does not yield a profit and obligations exceed the amount of incoming funds, the model crumbles. Bankruptcy may then result, and the ensuing case can be emotionally charged and present significant administrative and legal challenges for creditors and debtors. A recent example of such a case is the Land America bankruptcy, in which approximately 450 individual exchangers suddenly lost legal possession of their exchange proceeds when Land America filed for bankruptcy.

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