1031 Exchange Companies are not Regulated
Section 1031 of the U.S. Internal Revenue Code allows investors to defer capital gains taxes on the exchange of like-kind properties. The rules and processing of 1031 Exchanges can be quite complex (for explanations, NAR provides a resource list) and a cottage industry for facilitating 1031 Exchange has developed. Unfortunately, 1031 Exchange companies are not regulated, a fact that probably escapes almost all clients that use them.
Simply put, 1031 Exchanges require funds derived from the sale of an Exchange property to sit in a bank or escrow account of the 1031 Exchange company that is acting as a "qualified intermediary" while a like-kind purchase is being set up. Herein lies the fraud potential: qualified intermediary bank accounts, unlike escrow accounts, are not bonded.
Dean at Deansguide has been chronicling the April closure of 1031 Advance, a 1031 Exchange company based in San Jose that operates as a subsidiary of 1031 Tax Group in Virginia. He started with the story about 1031 Advance he had heard at a realtor marketing meeting last week and has been following up with information on potential assistance for those at financial risk from the closure. Yesterday, the San Jose Mercury picked up on the tragic side of the closure - funds seem to have disappeared and 1031 Tax Group filed Chapter 11, leaving estimated debt from more than 300 open exchange contracts at around $151 million.
With the downdraft in the real estate markets, unethical 1031 Exchange companies could be ripe for exposure as their portfolios might unravel due to market forces. Here are a few more problems that can happen with dishonest or mismanaged qualified intermediaries.
It seems the best advice for anyone contemplating a 1031 Exchange is to confirm that their funds sit in an escrow account, either run by a title insurance or an escrow company. I have some experience in 1031 Exchange in California, contact me if you're interested in learning more.
Technorati Tags: 1031 Exchange, 1031 Advance, 1031 Tax Group, Deansguide
Good post, Pat.
1031 Exchanges lie at the dangerous intersection of consumer ignorance and regulatory complexity. There aren't many investors/homebuyers who are doing these things day-in-day-out, so the consumer is often shaky on the concepts. Plus...the rules themselves are subject to layers of regulatory interpretation.
Best bet: go with a large title company who has it in their best interest to protect their public reputation. You might not get the absolute best deal in terms of rates and/or fees...but you won't get taken to the cleaners either.
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Pat,
Thank you for your piercing analysis on this ongoing fiasco. The law firm of Van Prooyen-Greenfield LLP is the media contact as well as customer contact. Granted they are "spin doctors" in the scheme of thing, but at least customers have a place to begin looking for answers.
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Great article, Pat. It shows how important it is to research who your Intermediary is, and how long they've been in business and if they're under the umbrella of a large corporation. Trying to save a few bucks can really hurt if something like this happens. Thank goodness this is fairly rare but unless and until there are strict laws about regulating intermediaries, cavet emptor.
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I must point out that leaving your proceeds in your escrow will destroy your 1031 Exchange. The IRS requires that you assign your interest as seller to a Qualifed Intermediary (Q.I.) prior to the close of escrow, and that at the close of escrow, the proceeds go to the Q.I. to avoid constructive receipt of the funds. All the big title company Q.I.s are pooling the exchange funds that they hold, and their fidelity bonds don't cover 1/10 of the funds they hold. If transparency is what you value, and I think it should be, make your Q.I. prove your funds are separately held by forwarding a statement directly from the depository bank in which they are held. At Haven Exchange, we do just that. Our customers receive monthly statements directly from Union Bank showing all activity, including interest earned. This proves the funds are separately held, in completely liquid, FDIC insured money market accounts. That's transparency. And our Fidelity Bond exceeds the total of all the exchange funds we hold. This level of security is unmatched in the Industry, and proves that the biggest is not the best in the case of Qualified Intermediaries.
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