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All Tax Deferred Exchange Companies Are Not Created Equal

When it comes to working with a qualified intermediary (QI) in a 1031 exchange, does it matter who is used as the QI if they follow all the rules? It is important that the company you choose to accommodate your exchange is not only qualified, but that they are knowledgeable of 1031 exchanges.
Warehouse

When to Use the Services of a Tax Deferred Exchange Company?

Many people and companies sell appreciated assets, such as real estate, and wish to acquire similar replacement assets without being subject to capital gain tax.  Also at times, taxpayers will sell an asset that has been depreciated, such as personal property or business use assets, and do not wish to incur tax caused by the recapture of that depreciation.  Almost always the sale and purchase are separated in time and the buyer of the old asset is not the seller of the new asset.  The ability to defer these tax consequences can be accomplished by the use of an Internal Revenue Code (IRC). The comprehensive set of tax laws created by the Internal Revenue Service (IRS). This code was enacted as Title 26 of the United States Code by Congress, and is sometimes also referred to as the Internal Revenue Title. The code is organized according to topic, and covers all relevant rules pertaining to income, gift, estate, sales, payroll and excise taxes. Internal Revenue Code Internal Revenue Code (IRC) §1031 tax deferred exchange or 1031 exchange.

As discussed in my recent blog post, “Are Tax Deferred Exchanges of Real Estate Approved by the IRS ”, in 1991, the IRS issued regulations governing these types of transaction.  Several of the key components of these regulations are the use of an intermediary to tie the sale and purchase together and as a party who can hold the sale proceeds until used to purchase replacement property from the taxpayer’s seller.  By using an intermediary the taxpayer is deemed to have sold the old property to the intermediary and through the intermediary to the buyer and to have the intermediary acquire the new property from the seller and transfer it to the taxpayer.  The taxpayer is deemed to have concluded an exchange with the intermediary.  The taxpayer can have up to 180 days to complete a purchase made after the sale.  Consistent with the fact that the transfer of the old asset is not a sale, but rather the first leg of an exchange, the taxpayer cannot receive the proceeds of the sale.  Instead the proceeds are held by the intermediary with or without the use of a trust or escrow arrangement.

Are All Exchange Companies Who Follow the Same IRS Rules Equal?

We know that the Declaration of Independence states that all persons are created equal.  Due to the U.S. Supreme Court’s recent holding in the Citizens United case, we also know that companies are persons too.  Does this mean that all exchange companies are equal?  No, they most definitely are not equal.  The recent South Dakota Supreme Court decision in Kreisers Inc. v. First Dakota Title Limited Partnership is a classic example of what can go wrong using exchange services from a company whose main business is something other than facilitating like-kind exchanges.

The Case of Kreisers Inc. v. First Dakota Title Limited Partnership

In the case of Kreisers Inc. v. First Dakota Title, the taxpayer was selling a property and intended to acquire a new property and use some of the proceeds from the exchange to pay for building a new warehouse.  These types of exchanges are somewhat complicated since the IRS will not allow the taxpayer to include in the value of the replacement property any money that the taxpayer puts into the property in the form of improvements once the taxpayer takes ownership of the property.  Rather, once ownership is taken, money spent for improvements is considered to be the payment of contractor services and the purchase of materials.  As such these costs are not like-kind to the sale of real estate.  The IRS approved safe harbor work around requires the exchange facilitator to take title to the property on behalf of the taxpayer and causing the desired improvements to be made using the exchange funds.  Once the taxpayer takes title to the property, the taxpayer is deemed to be acquiring improved real estate rather than paying directly for labor and materials. Please refer to one of my articles titled “IRS Issues Long-Awaited Reverse Exchange Rules” in our Resources Library for additional information.

In regard to the Kreiser’s case, as is frequently the case, persons involved on the title insurance side of the transaction held out that they could also provide §1031 exchange services.  There was no representation that the title company did not provide any exchange services other than simple, forward exchanges, which are paper transactions and do not involve the facilitator taking title to the property.  An attorney at First Dakota, who was also the manager of its title department, did double duty at First Dakota by facilitating exchanges.  Apparently there was very little dialog between Kreisers and the exchange representative.  The exchange documents were also sent to First Dakota’s outside counsel to review but no questions were asked by outside counsel to Kreisers.  Kreisers requested by phone that the title company representative call Kreisers’ local tax advisors presumably to get more information on the planned transaction.  According to testimony, that call was never made.  At closing, the closing agent at First Dakota briefly summarized the exchange documents and suggested that Kreisers sign a blank new property designation form, which would be filled in later by her to identify the replacement property.  Later, Kreisers acquired the new property and requested that First Dakota begin paying for the normal costs of a build out.  First Dakota declined based upon the fact that the exchange transaction was not set up as a typical exchange involving new construction.  Kreisers filed suit for negligence resulting in the loss of the tax deferral benefit.  They prevailed in the lower court and the matter was appealed to the state Supreme Court.

The South Dakota Supreme Court Decision

The court upheld the circuit court’s decision noting “The circuit court determined that First Dakota owed Kreisers a common law duty of care when First Dakota held itself out as being qualified to handle §1031 exchanges. First Dakota agreed to provide these services prior to signing any contract with Kreisers”.  Therefore, the circuit court concluded that “First Dakota had a common law duty to exercise reasonable and proper care in the handling of the §1031 exchange, including the drafting of the closing documents.” The Supreme Court decision went on to state

“Moreover, as the circuit court highlighted, Kreisers already believed that it had an expert in §1031 exchanges in First Dakota, which never informed Kreisers that its work was limited to forward exchanges.  It is important to once again note the complexity of these exchanges.  There is no evidence that anyone at Kreisers had any expertise in §1031 exchanges.  Kreisers was putting faith in First Dakota to properly exercise its knowledge and expertise to facilitate the §1031 exchange.  The circuit court’s finding that Kreisers was not negligent in not clear error”.

What Can be Taken Away from the Decision in the Kreisers’ Case?

Sometimes it is best to stick with what you know best, not trying to be all things to all people.   There are many companies whose primary business is facilitating §1031 exchanges, yet they do not have a secondary business acting as a title insurance company.  A taxpayer should do some due diligence before selecting an exchange services provider such as asking:

  • Are you a member of the Federation of Exchange Accommodators?
  • Are you compliant with all state required regulations of exchange facilitors?
  • Do you have Certified Exchange Specialists on staff?
  • What types of exchange services are provided by your company?
  • How many exchanges do you conduct annually?
  • Do you have a list of client references available?
  • Do you maintain a fidelity bond?
  • Are client funds put into a escrow or trust account?

It is important to make sure that if all pertinent facts are not given by the taxpayer, an experienced, dedicated exchange facilitator will know what questions to ask to solicit all things relevant.  Remember, not all intermediaries are created equal.