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How Lenders Protect Security Interests in 1031 Exchanges

Accruit

10/15/15

A successful like-kind exchange (LKE) requires that there be both relinquished and replacement property.  As such, equipment owners must actually sell old equipment and purchase new or used units as like-kind replacements.  Another LKE requirement states the proceeds generated from the sale of the old (relinquished) assets must be subject to specific restrictions.  These monetary restrictions are usually satisfied through employing a qualified intermediary (QI), whose responsibilities include safeguarding the sale proceeds...

A successful like-kind exchange (LKE) requires that there be both relinquished and replacement property. As such, equipment owners must actually sell old equipment and purchase new or used units as like-kind replacements. Another LKE requirement states the proceeds generated from the sale of the old (relinquished) assets must be subject to specific restrictions. These monetary restrictions are usually satisfied through employing a qualified intermediary (QI), whose responsibilities include safeguarding the sale proceeds until the replacement property is acquired. Found within Section 1031’s underlying restrictions and often referred to as the “g(6) restrictions,” these rules forbid the equipment owner from having any right to receive, pledge, borrow, or otherwise obtain the benefits from the sale proceeds residing in their like-kind exchange account.

Immediately after the sale transaction, the QI will typically receive the proceeds directly from the buyer. This deposit is usually net of various items, such as:

Broker fees
Auctioneer costs
Debt payoffs/pay downs

Generally, if the equipment owner were to receive any of the sale proceeds, or use it to pay off or pay down debt unrelated to the equipment being sold, the receipt could trigger a violation of the g(6) restrictions and possibly ruin the like-kind exchange.

For owner/operators, most equipment transactions are fairly simple and do not involve anything beyond pay offs or pay downs of debt related to the relinquished property. When the sale triggers a debt payment, it is a matter of instructing the broker, auctioneer, or buyer to send a portion of the purchase funds to the lender with any remaining amounts to be delivered to the qualified intermediary. However, there are cases where lenders (or lienholders) do not wish to receive payment related to the sale of the property. Instead, they seek to take hold of the proceeds or arrange for some sort of pledge against the funds held in the exchange account. While it’s understandable the lienholder would want to secure their interest in a traditional manner, these traditional arrangements would likely violate the terms of the g(6) restrictions and potentially taint the equipment owner’s like-kind exchange.

What’s a Lender/Lienholder to do?

In cases where the lienholder wishes to retain their secured interest, from sale of the relinquished property through the acquisition of the replacement property, there are three recommended techniques:

The Standing Disbursement Instruction
The Irrevocable Right to Approve
A Pledge of A charge paid by a borrower to a lender for the opportunity to borrow funds via a loan or the funds earned by an account owner/beneficiary on the amount held on deposit. Interest in a New Subsidiary

Each technique may be done through adding specific language directly to the like-kind exchange agreement with your QI, or through a separate agreement.

Standing Disbursement Instruction

The standing disbursement instruction simply states that at the end of the exchange, any remaining exchange funds shall be paid to the lienholder, rather than back to the equipment owner.

The Irrevocable Right to Approve

The irrevocable right to approve method inserts the lienholder into the process for:

Identifying replacement property and,
disbursing exchange funds for the acquisition of the replacement property.

This method requires the lienholder physically sign any LKE identification forms and disbursement requests made of the quailified intermediary.

A Pledge of Interest in a New Subsidiary

A pledge of interest in a new subsidiary requires that the equipment owner, prior to the sale, transfer the relinquished property into a single member limited liability company (LLC). The lienholder then takes a pledge of this new LLC’s interests as security. After the sale of the old property the lienholder retains a secured interest in the LLC, with the LLC’s primary asset being the amount held by the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary .

Summary

All three of the above methods may be used separately, or together to mitigate the lienholder’s security risks. After the acquisition of the replacement property, the lienholder may make standard arrangements to directly attach a lien on the replacement property. It is advisable that all parties seek the advice of an experienced tax attorney. Failure to address security concerns can be risky for the secured party, and failure to address these concerns correctly can be potentially invalidate the equipment owner’s like-kind exchange.