The Ghost In The Machine On 1031 Title Exchanges

Section 1031 of the U.S. tax code allows people who have capital gains from real estate sales to defer tax exposure on those profits. To do so, they must use those profits to purchase a similar property within 180 days of the original sale, and they can never touch the money themselves. This process is known as a 1031 title exchange. For obvious reasons, they are popular with real estate investors.

The law exists to encourage investors to put their money back into circulation instead of just putting their profits in a bank, where only the investor benefits. That’s why you’re allowed to do 1031 exchanges as many times as you like. However, the key element is that you can’t physically touch any of the profits. If you put them in your bank for even one day, the profits are subject to taxation.

Investors navigate this hurdle by turning their profits over to what is known as a qualified intermediary.” A qualified intermediary is a company that holds your profits and then releases them at your command when you find a new property. It sounds simple, but a gaping regulatory hole in the process means that you must be careful choosing a qualified intermediary.

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Qualified Intermediaries Are Very Loosely Regulated

When you turn your money over to a real estate broker or an attorney, strong regulatory oversight determines how they can handle client funds. These regulations are designed to make it difficult for them to act improperly or steal your money.

They must maintain their client’s monies in trust accounts separate from the operating account for their law firm or real estate brokerage. They are legally prohibited from commingling the funds or using client money for any purpose other than the transaction or legal services the monies are pledged for. They are also required to reconcile all of their trust accounts on a monthly basis.

These entities must compile a ledger that catalogs the dates and reasons for deposits and withdrawals from their trust accounts. They are required to balance this ledger against the monthly bank statements and keep records of their reconciliations available for inspection by state representatives at any time during normal business hours. The failure to do so can result in losing their license, even if no money was taken.

The problem for real estate investors is that no equivalent regulatory body at the federal level is responsible for oversight of qualified intermediaries. The IRS even has a warning about these entities on its website. At the state level, only eight states regulate or oversee the conduct of qualified intermediaries. They are:

  • New Hampshire

  • Virginia

  • Washington

  • Maine

  • California

  • Idaho

  • Colorado

  • Nevada

That means a qualified intermediary in the other 42 unregulated states could theoretically go hog wild with your 1031 exchange money, and as long as they released it at your request when you completed your exchange, you wouldn’t be any the wiser. That’s a scary thought and the very definition of a ghost in the machine.

What If Your Qualified Intermediary Runs Off With Your Money?

In spite of the lack of federal and state regulation of qualified intermediary companies, it’s still a crime for them to misappropriate your money. If they run off with your money and don’t pay it when you demand it, they could be subject to prosecution and imprisonment. However, that doesn’t solve your problem as an investor.

Remember, you only have 180 days to make your exchange. That clock doesn’t stop ticking under any circumstances. So, if your qualified intermediary doesn’t have your money when you need to make your exchange, and you can’t complete it within 180 days, you’re subject to capital gains tax on your stolen money.

A qualified intermediary runs off with your money and sticks you with a tax bill in the process? Ouch. In some cases the qualified intermediary’s insurers will pay back a portion of the money, but that’s unlikely to happen in enough time for you to complete the exchange. So, choosing the wrong qualified intermediary can literally cause a financial nightmare that will take years to wake up from.

Does Qualified Intermediary Theft Happen Often?

Thankfully no, it doesn’t. But when you consider the fact that qualified intermediaries can be holding profits from dozens, or even hundreds, of real estate sales at a time, just one qualified intermediary doing the wrong thing can cause millions of dollars worth of havoc.

Take the case of Edward Okun, who was the former head of the 1031 Tax Group. He ran his qualified intermediary company into the ground by using client money to fund a luxury lifestyle that included mansions in multiple states, several boats and lots of jewelry that he lavished on his bikini-model wife.

When he finally ran out of money and couldn’t pay his clients, they didn’t know what was a bigger shock: finding out their money had been stolen or finding out there was no regulatory framework or oversight in place to prevent Okun from stealing it. At the time of his arrest, Okun was finalizing a deal to buy another qualified intermediary company with nearly $900 million on deposit.

He was sentenced to 100 years in jail and forced to forfeit almost $40 million in property. Eventually, his jilted clients ended up with about 70% of their money. However, that 70% did not come in time to pay their tax bill, which they had to pay out of pocket, and they still incurred legal fees while pursuing him for damages.

How Do You Protect Yourself From A Shady Qualified Intermediary?

Edward Okun is not alone in using qualified intermediary companies to commit financial impropriety. There are numerous cases where qualified intermediaries have been caught, and the losses from these cases run into hundreds of millions of dollars. In spite of this, there is still no federal oversight of the industry. So, how do you protect yourself from a shady qualified intermediary?

If you don’t live in a state that regulates qualified intermediaries (and you probably don’t since there are only eight of them), your best bet is probably to choose a qualified intermediary who is also a state bar-certified attorney. At least then they will be required to conduct monthly account reconciliations.

It’s no guarantee, but it will give you some peace of mind to know your chosen qualified intermediary has the state bar association looking over their shoulder. Second, do your research. Check the intermediary’s on-line reviews. Do they have a reputation for being responsive and proactive about communicating with clients? Is their BBB rating high? Ask hard questions when you interview qualified intermediaries. Get the answers you want or move on to the next one.

You Must Protect Your Own Interests In 1031 Exchanges

Before a boxing match, the referee calls both fighters to the ring and tells them “keep your hands up and protect yourself.” This solid advice applies to investors working through a 1031 title exchange. It’s your responsibility to choose your qualified intermediary cautiously and with extreme care. You worked hard to get profit out of your investment. It’s up to you to protect it.

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Source: https://finance.yahoo.com/news/ghost-machine-1031-title-exchanges-153416295.html