Protecting Your Money: How to Avoid Risk in Your 1031 Exchange

This past year proved to be one with huge failures and widespread anxiety. With the disappearance of large companies like Lehman Brothers and Washington Mutual, it is no wonder that investors do not know where to put their money. These concerns have had an impact on all aspects of the real estate industry, including the 1031 exchange industry. Moreover, to make matters worse, several exchange companies have failed during the past two years, resulting in the loss of millions of dollars to investors. These failures have highlighted the importance of selecting an intermediary based on its financial strength and integrity.

The intent of this article is to explain some recent legislative developments related to choosing an intermediary and provide recommendations regarding those factors most important to consider.

Section 1031 Rules

Under Section 1031 of the Internal Revenue Code, an investor can sell investment real estate and acquire replacement real estate within 180 days; and if all of the rules are followed, the tax from the gain on the sale is deferred. An exchange company, also called a qualified intermediary, accommodator or facilitator, is an entity that acts as a middleman for investors wanting to do a 1031 exchange. In order to accomplish a 1031 exchange, an investor must enter into an exchange agreement with the intermediary, and the intermediary must hold the proceeds from the sale of the property until they are used to purchase replacement property. If the investor holds the funds, the transaction will be treated as a taxable sale instead of a tax-deferred 1031 exchange.

Intermediary Business

Because intermediaries must hold the proceeds from the sale until the replacement property is purchased in an exchange, these companies hold millions of dollars of investors’ money. The intermediary business includes companies of all sizes. Many intermediaries are owned by large banks and title companies, but there are also numerous independent exchange companies that are small, unregulated businesses. Amazingly, until recently, there was virtually no regulation of qualified intermediaries under either federal or state law.

Failed Exchanges

In most cases the money is handled properly and is available at the time that the client needs to close on the purchase. In several instances in the last two years, however, the intermediary closed its doors and left investors wondering what happened to their money.

Investors who lose their money when an exchange company fails not only risk losing all of their cash, but if they have entered into a contract to buy the replacement property, they could be subject to a lawsuit for failure to acquire the property. In addition, they lose their ability to defer gain in a 1031 exchange and, therefore, have to pay the tax that is due because of the sale of their property. In May 2008, Congressman Bill Delahunt of Massachusetts asked the IRS if there was something that could be done for his constituents who had started a 1031 exchange but were unable to complete it because the intermediary had filed for bankruptcy protection. On June 6, 2008, the Office of Chief Counsel at the IRS responded that taxpayers are not able to defer gain in a 1031 exchange if they do not buy replacement property within the 180-day exchange period, even if the reason for the failure to buy replacement property within the 180-day period is due to the bankruptcy of the intermediary. In other words, the IRS does not give any special treatment to investors who have lost their money because of a failed exchange company.

New Regulation of Intermediaries

A few states, including Nevada, Idaho and, most recently, California, have responded to the recent exchange company failures by issuing new regulations of qualified intermediaries.

The new California law is effective January 1, 2009. The law creates a new standard that intermediaries must follow in deciding where to invest exchange funds. Starting in 2009, intermediaries must meet a “prudent investor standard,” satisfying the goals of both liquidity and preservation of capital, when investing exchange money. The law also requires that intermediaries maintain a fidelity bond of at least $1 million (or set aside cash, securities or a letter of credit in the same amount, or use special qualified trust or qualified escrow accounts with dual signatures required), and maintain errors and omissions insurance of at least $250,000 (or deposit cash, securities or a letter of credit in the same amount). Exchange funds cannot be commingled with the intermediary’s operating funds and cannot be loaned or transferred to an affiliate of the intermediary, other than an affiliated financial institution.

The new law also requires intermediaries to notify clients when there is a change in ownership of the intermediary of more than 50%. This may be relevant if the client chose the company initially based on the client’s relationship with the original owner. The law specifically prohibits certain bad acts, such as fraud. Finally, the law says that exchange funds are not subject to attachment by the intermediary’s creditors. This is good news for investors but also for intermediaries who want to assure investors that their money is safe.

While these changes will not prevent fraud, they do create a cause of action for fraud and for failure to use the appropriate investment standards. They also make it clearer what the responsibilities of exchange companies in California are.

Selecting an Intermediary

What is a concerned investor to do? There are several things that an investor should consider when choosing an intermediary and setting up an exchange.

Financial Condition

First, carefully consider the financial condition of the intermediary. Many intermediaries are owned by banks and title companies. Although recent news stories may indicate to some that there is risk even in the largest institutions, it is still prudent to start with companies that are large and publicly traded. From this pool, a careful investor may want to narrow his choices further by considering only companies that are owned by banks and title insurance companies with the strongest balance sheets.

Regulated Companies

It is also better to use companies that are highly regulated. While there are many federal regulations, rulings and cases that address how to do an exchange, there is no federal regulation or licensing of intermediaries. As discussed above, state regulation of intermediaries is minimal. Because of this, investors should work with institutions that are subject to banking or title insurance regulations, which contain numerous checks and balances that do not apply to other entities.

Investment of Funds

Another important consideration is to determine where the funds are being invested. There is danger in an unregulated environment that an intermediary would invest funds in an illiquid and risky asset, such as real estate. The funds may not be available when needed for the exchange. In addition, the intermediary business is very competitive, which can motivate companies to invest funds more aggressively in order to be able to give the investor a better yield. While yield is important, investors should look for companies that invest exchange funds in conservative and liquid financial instruments, such as deposit accounts.

Bonds and Insurance

It is wise to consider whether an intermediary has a fidelity bond, and errors and omissions insurance coverage; but it is also important not to rely on either form of insurance too much. Most intermediaries use the existence of a fidelity bond and errors and omissions insurance as a marketing tool. It is a prudent business practice to get the insurance, but clients should understand what it really is.

A fidelity bond is a form of insurance from a bond company that protects an employer if someone is harmed because of the dishonesty of one of its employees. This insurance does not apply, however, when an exchange company is owned by one person and that person commits the fraud. In addition, it is not always possible to verify whether a company actually has the bond that it says it does. Although bonds are useful to manage risk and provide insurance coverage for losses, they do not eliminate the need to consider other factors when choosing an exchange company.

Errors and omissions insurance policies provide insurance coverage for claims by clients because of negligence. As discussed above, this is useful insurance for an exchange company to have but does not remove the need to carefully choose an exchange company.

Separation of Exchange Funds from Operating Funds

There are also several things an intermediary can do to bolster the argument that exchange funds are not subject to attachment by creditors if the intermediary should become insolvent. First, exchange funds should never be commingled with the intermediary’s operating funds. Many intermediaries combine exchange funds from multiple exchanges in one bank account even though they account for each transaction separately, but these exchange funds should not be commingled with the funds that are held by the intermediary for its own operations. Another layer of protection is to set up each exchange in a separate account under the name of each taxpayer.

Conclusion

In February of 2008, the IRS issued a public announcement summarizing the rules related to 1031 exchanges. In the announcement, the IRS told investors to “be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer.” Smart investors will heed this advice and pay attention to the guidelines described in this article when choosing an intermediary and doing a 1031 exchange.

Reprinted with permission by Black Point Press. This article was originally published under the title “Friend or Fraud” in the January 2009 issue of Apartment Management Magazine, CAA Tri-County Division.