Avoiding Fraud in an Unregulated Industry

The recent difficulties of Qualified Exchange Services (QES) in Santa Barbara and its affiliate company Southwest 1031 Exchange in Nevada have raised concerns by real estate investors about the safety of the 1031 exchange process and how to select an honest facilitator to control their money during transactions. For the uninitiated, a tax-deferred exchange is a method for selling and buying investment real estate without paying capital gains taxes.

Internal Revenue Code §1031 provides the basis for these transactions and requires the use of an independent entity – a “qualified intermediary” (QI). The QI receives and holds money from the sale of property until replacement property can be purchased. During the time funds are held, they must be beyond the control of the investor and, more importantly, under the control of the QI or the transaction may become taxable under IRS regulations. The QI industry is unregulated, so each company works differently to meet IRS exchange requirements – a recipe for confusion and potential disaster.

Since the delay between the sale and purchase can be as long as 180 days, a QI can control substantial sums of money over many months. The failures of QES (approximately $12 million missing) and its affiliate Southwest Exchange (approximately $90 million missing) are creating shock waves in real estate circles, causing investors to search for clues to select a safe, experienced and knowledgeable QI.

While there are no magic bullets here, there are important questions to ask when looking for a qualified, honest facilitator who would be holding potentially large sums of money during a tax-deferred exchange. Here are a few.

Protecting Your Assets

A good first question to ask is what “security” is provided for funds held? Some companies offer a unique Bank Guaranty. The bank holding the funds guaranties to the investor that the funds are safe and will be available to acquire replacement property. Many banks offer this protection to exchange corporation clients at no charge. Such security arrangements at other qualified intermediary companies can include third party guaranties, standby letters of credit and qualified trust accounts.

A second question should focus on how the money is managed while it is under the control of the QI. Each exchange account should be segregated from other funds so the safety of the funds can be instantly determined. Unfortunately, most QIs commingle funds in a single account, usually to increase the interest the QI can earn during the holding period. This is how QIs pay themselves an amount greater than what they openly charge their clients. QIs may earn 2% to 4% interest on the funds while they’re holding them. Some have kept 100% of that interest. Until recently, less than 10% of QIs nationally allowed their clients to earn the interest. The IRS is currently looking at requiring QIs to disclose to clients the portion of interest the QI has taken. Providing clients with factual knowledge of the total fees paid for their exchanges could reduce the incentive for commingling funds – a positive step toward deterring QI fraud.

A good third question to ask: Is the QI bonded and what does the bond cover? Superficially, a fidelity bond sounds like good protection, but bonds usually only cover theft by employees, while misuse of funds by QI owners is not protected. In the QES/Southwest situation, there appear to be two problems with the bond they advertised. First, the owner let the bond lapse. (It cost the company approximately $60,000 a year to maintain the bond.) Second, because the employees are apparently innocent of theft in this situation, it appears the bond may not have covered the losses anyway. Furthermore, protection is for loss of funds only and will not cover tax liabilities and other costs investors might incur in connection with attempts to recover their funds.

A tax liability arises when property is sold in an exchange and new property is not acquired within the allotted 180 day period. Investors who have lost money in the QES/Southwest situation will be unable to reinvest their “gain” into a replacement property within the “exchange period” so the income consequences (the capital gains) from their failed exchange will be recognized this year. Their tax deduction for the loss of funds, however, will not be available until those funds are determined to be uncollectible by IRS standards, which could be years from now.

The QI industry has long been in danger due to lack of regulations and standards. The Federation of Exchange Accommodators has ethical and moral requirements for membership, but unfortunately, QES and Southwest Exchange were members in good standing until it was too late to protect anyone. One might look to governmental regulation as a solution, but even if such regulation did exist, rules could not have prevented Southwest principal Don McGhan, whose questionable reputation was apparently of record, from gaining control of QES’ exchange proceeds. Why? Because anyone can offer to buy a QI’s book of business, just as anyone can offer to buy any kind of privately or publicly held company in America. It’s up to the selling QI’s principals to carefully scrutinize any offer they receive from a buyer before accepting it.

Unfortunately, no matter what the reason for lost funds, when any element of the 1031 exchange system fails, the result for clients is tragic. Thus, the experience and expertise of every QI and its principals are paramount. While again not foolproof, some protections do exist:

1. Learn as much as possible about prospective companies.

2. Look to “experienced” CPAs, attorneys, banks, reputable Realtors and real estate investors for referrals. Ask who they have worked with and referred clients to in the past. Recommendations based on friendship or insufficient knowledge of a QI is not good enough.