A recent report in the Wall Street Journal highlighted yet another 1031 exchange company that had stolen real estate investors’ funds and used them to fund an expensive lifestyle.
Thousands of real estate investors have used 1031 exchanges to defer capital gains and other taxes due when buying replacement investment property. When the rules are properly followed, a 1031 exchange–also referred to as a Starker trust or Starker exchange–allows a real estate investor to buy and sell real estate without having to pay any federal income taxes on the sale of the property. The payment of any taxes is deferred until the owner of the property dies or sells the property and does not use a 1031 exchange.
1031 exchanges are generally used for real estate transactions but can also be used for investments in other types of properties including airplanes, cars, trading cards and even musical instruments. But these investments have to be true investments and the sale of one must be followed by the purchase of another like kind investment: a real estate asset for another real estate asset, or an airplane for an airplane.
According to Scott Nathanson, senior vice president of Nationwide Exchange Services, a company that acts as a qualified intermediary, the problem is that 1031 exchange companies are unregulated, and security isn’t high on their list of priorities.
“Making sure that taxpayers’ 1031 funds are secure is expensive and time-consuming,” Nathanson says. “So a lot of 1031 exchange companies don’t do it.”
In the past few months, Nathanson says, the faltering economy and slowing real estate market have meant trouble for many 1031 exchange companies that aren’t quite on the up and up.
In Chicago, two attorneys who operated small 1031 exchange intermediary companies in addition to their legal practices were found to have skimmed a million dollars, in one case, of real estate investors’ funds. In one of the cases, the attorney skimmed a little bit from each of the real estate investors’ funds over many years, Nathanson explained.
But the sheer magnitude of some of the cases, which Nathanson and investigators refer to as Ponzi schemes, is startling.
In Denver, the owner of the Southwest Exchange, Inc., acquired a number of small 1031 exchange companies, combined them together and then took $100 million of $150 million in funds to invest in some European breast implantation technology.
“As long as there is new money coming in that you can use to pay out the 1031 exchange funds that have to go out, you’re okay,” Nathanson explains. “But as soon as the market slowed, he needed to get those funds back into the 1031 exchange company, but apparently couldn’t.”
On the east coast, the owner of another 1031 exchange company used the company as his private piggy bank, pulling another $100 million out of it for personal use.
Nathanson says that real estate investors looking to do a 1031 exchange should ask companies a few basic questions to help establish where their funds will be held and how safe they are.
First, ask where the funds will be held and how they will be held. Nationwide Exchange Services, which Nathanson believes is the only 1031 exchange company that is Sarbanes-Oxley Section 404 compliant, only holds funds in FDIC banks. Not only that, the funds are held in a special escrow trust account so if a bank goes under, the funds are safe even if there is more than $100,000 in the account.
Nathanson says it takes an extra day to get the funds out of the special trust account, “but it’s amazing how patient people have become in the wake of the Indymac Bank failure.”
Next, ask if the 1031 exchange company has a fidelity bond and if you can get a copy of it. Nathanson says his company has a $55 million fidelity bond to protect customers.
“In a bad economy, where 1031 exchange companies cut corners is with the bonds, which can be expensive,” he adds.
Finally, ask if the 1031 exchange company carries errors and omissions insurance on each exchange. The answer you’re looking for is yes, because the E&O policy covers mistakes such as funds being erroneously wired to the wrong location.
If you have 1031 exchange funds held with a company that doesn’t follow best security practices, the end result can be devastating.
“The IRS is unforgiving on this issue because they say you have the right to choose any 1031 exchange company you want. If you choose a company that turns out to be a bunch of crooks, the IRS says it’s your problem. You still owe the taxes” even if you can’t buy a replacement property and you have lost your money, Nathanson explains.
How much could you owe? If you failed to complete the 1031 exchange for any reason, you’d owe capital gains tax on your profit, any state taxes that would have been due and the recapture on any depreciation you took.
In short, you could be completely wiped out, especially if you have been doing 1031 exchanges over and over again, deferring hundreds of thousands or dollars in profits.
“It’s most people’s life savings, and they never ask these important questions about security. What we are often asked is why we’re going to keep the funds in a trust account that only earns 2 percent,” Nathanson says. “They keep asking if there isn’t a place where we could earn a little more.”
July 31, 2008