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Hidden Dangers In 1031 Exchanges

The November 2008 bankruptcy filing of leading 1031 exchange accommodator LandAmerica should alert all real estate investors to the real perils regarding what firm they choose for handling their 1031 exchange and holding their funds. 1031 exchange accommodators, also known as qualified intermediaries, hold funds in escrow from real estate investors who have sold a property at a profit and have 180 days to close on the purchase of a replacement property (which must be identified within 45 days of the sale of the original property) in order to defer capital gains tax on the profits. In the case of LandAmerica’s Exchange Services (LES), the company held hundreds of millions of dollars from more than 400 real estate investors.

Unfortunately for real estate investors using LES, their funds were placed into a pooled or commingled account and have gotten caught up in the parent company’s bankruptcy filing. LandAmerica got itself into trouble by investing this commingled money in 20-year maturity auction-rate securities backed by student loans. In the past, there was an active liquid market for these securities so LandAmerica was able to pocket millions of dollars in interest investing their 1031 customers’ money. Due to the turmoil in the financial markets in 2008, the market for auction-rate securities dried up and pushed LandAmerica into bankruptcy.

All of this could have been avoided if LandAmerica had their customers use separate or so-called segregated accounts whereby each 1031 exchange customer would have an account in their name titled such as “for the benefit of Joe Property Investor” in an FDIC-insured bank. In that case, the 1031 customer money would be protected from bankruptcy and lawsuits against the accommodator or parent company, etc.

State departments of insurance regulate title and escrow companies so this problem of an escrow company taking homebuyer or seller funds down with them in a bankruptcy can’t happen in a regular residential real estate transaction. 1031 companies are unregulated entities and few people understood the risks of real estate investment customers’ funds at companies like LandAmerica using commingled accounts. LandAmerica was named Fortune magazine’s number one most admired company in the mortgage services industry in 2007.

Mary Foster, who is the immediate past president of the trade association of 1031 intermediaries — the Federation of Exchange Accommodators — interestingly does not advocate that their members use segregated accounts. “Our association supports using prudent business models,” she says. Her own 1031 intermediary company uses segregated accounts held in local banks.

Foster says that some 1031 accommodators quote lower fees to handle a 1031 transaction and then make up for that lower fee by gaining the investment interest on the customer’s funds. While she says that the FEA’s ethics code requires disclosure of the interest portion of the compensation, their association doesn’t conduct audits to see if disclosure is actually happening.

Even more important than the disclosure of the investment earnings on the client’s funds is the risk that the 1031 exchange company is taking on when placing the 1031 exchange customer’s money into a specific investment.

In the case of LandAmerica, it turns out some of their customers might have chosen the safer path for their funds and been protected. LandAmerica’s third-quarter financial filings stated the following: “The like-kind exchange funds are either invested in a commingled account ($290.5 million at Sept. 30, 2008), or if requested by the taxpayer, in a separate account designated by the taxpayer ($110.2 million at September 30, 2008).” So, while most of LandAmerica’s 1031 exchange customers unwittingly placed their own funds at risk and cannot get them back now due to LandAmerica’s bankruptcy, those who requested their money be placed in separate accounts may be able to get their money back through an attorney’s request. Those folks might still be able to complete their 1031 exchange and reap the tax benefits they expected.

Gary Gorman, founder of 1031 Exchange Experts, a 1031 qualified intermediary company based in Denver, Colo., has been critical of his peers using commingled accounts because it puts their customers’ money at risk in a bankruptcy. He also alleges that title companies such as LandAmerica and Fidelity National “… make it very difficult to use someone other than themselves as an intermediary for a 1031 exchange. Fidelity National has fired people for referring outside the company and requires that their 1031 customers provide a written confirmation to use an outside 1031 intermediary company.”

Gorman also alleges that these same title companies run afoul of laws governing title companies to give three choices for when they refer customers to entities like their 1031 exchange divisions that are affiliated with their title company.

LandAmerica isn’t the first 1031 exchange company to take client money down with the company. 1031 Tax Group, a Richmond, Va.-based 1031 accommodator, and Southwest Exchange of Henderson, Nev., both went under in 2007 with possible fraud involving more than $200 million missing between these two companies.

In addition to real estate investors conducting a 1031 exchange using an intermediary who uses segregated accounts for their customers, investors should also be sure the full value of their account is protected at the bank they use. FDIC insurance is generally limited to $250,000 per account holder.

Also, CPA and tax lawyer Scott Haislet, who has done 1031 exchanges for 20 years, points out that some 1031 customers may not realize when they aren’t in compliance with tax rules. “1031 exchange companies don’t provide tax advice,” he cautions.