Friday, March 13, 2009

Dis-Qualified Intermediaries

When I was a young commercial investment sales broker, I wasn't quite sure how 1031 Exchange Qualified Intermediaries made money, and didn't really care so long as they helped me make money. All I knew was that the IRS required these "qualified" intermediaries to handle the proceeds from an investment sale until a like-kind property was identified by the seller to buy, lest their capital gains on the sale of their property be subject to the tax code. The purpose was to prevent the individual sellers from making money on proceeds from the sale without paying taxes on them (even thought these intermediaries generally paid investors between 0.5-1% in exchange for holding the money).

As it turns out, I wasn't the only one who didn't get it. In the last several months, some of the biggest 1031 intermediaries were either sued, or filed for bankruptcy, placing investors who used them to facilitate their 1031 exchanges in a very precarious position.

Now, before we delve into this mess, let us first step back to the broader picture. 1031 exchanges are facilitated of course by the velocity of sales transactions of property. Simply put, if there are fewer properties being sold, there are going to be fewer 1031 exchanges. Almost a self fulfilling prophecy, the reason velocity is down contributes to an entirely different, but substantial reason for the decline in 1031 exchanges. With property values plummeting, even those property owners who have found a legitimate reason to sell are finding that the "gain" on their property has dwindled to a point where doing a tax-deferred exchange is seemingly pointless, because there isn't a ton of increased value (if any), from the time they bought the asset, to protect from the IRS. I digress....

Back in 2006 during the heyday of the boom in commercial real estate, there were 1031 exchanges happening left and right. The irony of the term "Qualified Intermediary" is that there is nothing "qualified" about them. They are not regulated in any way, nor are the ways in which they invest their clients' funds in the interim until it is time to fund the new property they are buying. No licenses are required, and Nevada (of all states, given whats legal there) is the only state that imposes any regulations.

Intermediaries make money in several ways. Most charge transaction fees, while others earn the spreads between interest they gain on investors' proceeds and the interest paid out to investors.

In 2007, three big intermediaries were charged federally with misappropriating clients funds. One ran a Ponzi scheme (Southwest Exchange, Inc. and Qualified Exchange Services), and another (1031 Tax Group) used monies to fund private real estate transactions, of all things.

One would think investors would have wised up and only invested their funds with bank or securities related intermediaries, or those that are part of the Federation of Exchange Accomodators, a trade organization that performs background checks of all its members looking for previous illegal or fraudulent activity.

Unfortunately, even those "safe" intermediaries investing appropriately, and in some cases, only in securities considered very liquid, were not immune from losing their investors money.

The most public of which was Land America, at the time the third largest title insurance company in the nation, as well as a busy 1031 exchange qualified intermediary. The investors, from retirees to a public company, had $400 million on deposit with the LandAmerica subsidiary, who has sold their title insurance company to competitor Fidelity National Title Insurance Co., and will likely be liquidation their 1031 Exchange arm.

In the filing, the company said it had put much of the money it was holding for real-estate investors into commingled accounts that invested in auction-rate securities that have become illiquid. LandAmerica had guaranteed the money. The auction-rate securities market seized earlier in 2008.

Investors, who thought their exchange and their money were safe, have been put in the precarious position of having to sit through bankruptcy proceedings just in order to get their money back. The biggest problem, again due to lack of regulation, is that there was no transparency for investors to see how these intermediaries were investing their money.

While this isn't necessarily an instance of robbing Peter to pay Paul, rest assured that Jesus was consulted by furious investors on more than one occasion.


Doug Cornelius said...

I think you want to be careful about lumping the bad 1031 QI's together with LandAmerica. Those bad guys were stealing money.

LandAmerica got duped (like many investors) and were told the ARS were very liquid and very safe. Of course it turned out that they were not liquid and not safe.

How about some steps investors can take to protect themselves? Here are some:

Anonymous said...

Good stuff

John Hamrick said...

Like any industry, a few bad apples...There are many compelling reasons to use Section 1031 as a powerful strategy for not only deferring capital gains, but the compounding effect of using Uncle Sam's money to boost your own portfolio, over and over and over again.

A "real" Qualified Intermediary makes their money by running a consultive practice whereby they are available to professionals and consumers alike to help determine if Section 1031 is right for their particular transaction.

A "real" Qualified Intermediary will NEVER do anything with client funds except for to deposit them into a well capitalized banking institution in SEPARATE accounts using the client's taxpayer ID on the account.

A "real" Qualified Intermediary will protect at all costs the safety and security of client's funds up to and including protection against errors and omissions and yes, fraud and bad deeds within their own organizations.

The primary reason that the clients of LandAmerica are in trouble is because they were lulled into a false sense of security because the company was so BIG. It's amazing how even the best of us forget the basic rules of due diligence when we deal with companies that seem so huge.

I guess we have learned over and over again during the past 6 months that bigger is not better, and that indeed, the bigger they are, the harder they fall.