From Florida Association of Realtors
A popular tax-deferral trick for real-estate investors is facing scrutiny as key middlemen in the strategy run into financial trouble.
The problems are starting to leave investors with significant losses, and raising the possibility of increased oversight of a lightly regulated corner of the real-estate investment world. In at least one instance, a firm that helps investors defer taxes this way is facing allegations of fraud.
The strategy, known as a 1031 exchange, lets investors who sell investment properties defer capital-gains taxes if they invest the proceeds in “like kind” property within 180 days. To qualify for the benefit, the seller can’t touch the money from the sale. Instead, the funds must go into an account until they are used for the purchase of a new property.
That’s where the money can be vulnerable.
These exchanges have been around for nearly 90 years, but their popularity has increased in the past decade as the number of real-estate investors has exploded. In a 2005 study by Deloitte Tax LLP, there were about 220 million 1031 exchange transactions in 2003 totaling about $200 billion in value, the most recent data available.
The accounts for 1031 exchanges are typically handled by a party called a “qualified intermediary,” also called an accommodator or facilitator. While many so-called QIs are part of banks or title insurance companies, the QI business is largely unregulated. There are hundreds of independent QI businesses across the country.
Furthermore, a QI can do virtually anything with the funds in its possession, subject to its agreement with the taxpayer. “There isn’t any kind of prohibition in the tax code that says where those dollars can be placed,” says John King, senior vice president at a subsidiary of Fidelity National Financial in Jacksonville that serves as a qualified intermediary.
The past several months have seen at least two big cases of independent QIs running into trouble. One case involves a businessman named Donald McGhan and his two qualified-intermediary companies, Southwest Exchange Inc., based in Henderson, Nev., and Qualified Exchange Services Inc., based in Santa Barbara, Calif.
McGhan and his companies allegedly misappropriated more than $95 million of customers’ proceeds to fund other business and personal activities, according to a lawsuit brought earlier this year by several aggrieved investors and now in federal court in Los Angeles.
The lawsuit alleges that Southwest was a Ponzi scheme in which McGhan allegedly took QI funds belonging to more than 130 clients, in part to finance investments in a company that manufactures silicone-breast implants.
Mark Dzarnoski, a lawyer at Gentile DePalma Ltd. in Las Vegas, who represents McGhan, says “the plaintiffs in these lawsuits have used inflammatory language referring to people as ‘thieves’ and alleging the stealing of money, but the real issue under the law is what qualified intermediaries are able to do with the money they receive from their customers.”
Another case involves 1031 Tax Group LLC, which filed for bankruptcy protection in New York on May 14. More than 300 investors across the country are owed an estimated $151 million by 1031 Tax Group, according to court filings.
The company’s owner, Edward Okun of Miami, borrowed money from 1031 Tax Group to fund real-estate investments made by Investment Properties of America, another company controlled by Okun, according to a sworn affidavit made by Jim Lukenda of Huron Consulting Group, which was recently brought in to help restructure the company. Okun has acquired six regional QIs over the past two years; all are affiliated with the 1031 Tax Group. Federal prosecutors in Richmond, Va., have begun a preliminary investigation into the case, court records say.
“Mr. Okun has done absolutely nothing wrong,” said Michael J. Rosen, a lawyer in Miami representing him. “And by voluntarily placing the company into bankruptcy he took the appropriate steps to protect his customers, though I understand their being upset.”
Candace Graham, a real-estate investor from Portola Valley, Calif., is owed roughly $3.3 million by 1031 Tax Group, according to a bankruptcy court filing. In February, Graham, 58, sold an office building and, to defer taxes, placed the proceeds with a subsidiary of the 1031 Tax Group but hasn’t been able to gain access to the funds to buy another property.
Because her deferral strategy fell apart, she faces the prospect of a capital-gains bill. “I have no idea how I will pay the government now,” said Graham.
Clarissa Potter, deputy chief counsel of the Internal Revenue Service, says the agency is following the trouble. “We know taxpayers may face disruptions when an intermediary cannot meet its obligations,” she says.
People involved in the market note that it is large and diverse. The actions “of a few persons should not taint either the broad 1031 market, which allows taxpayers to save significant taxes legally, or the honest QIs who provide a useful service at low cost,” says Richard Lipton, a tax lawyer at Baker & McKenzie in Chicago.
Michael Halloran, chief executive officer of Nationwide Exchange Services, an independent qualified intermediary with about $10 billion in exchange activity in 2006, says, “You have an industry that is growing up and changing, and something has to be the catalyst for that change.”
QI businesses make money in several ways. Most charge transaction fees, while others also earn the spread between interest they gain on 1031 investors’ sale proceeds and the interest paid out to the investors.
Many large financial institutions have QI services business. J.P. Morgan Property Exchange Inc. is a unit of J.P. Morgan Chase & Co.; Wachovia Exchange Services is a unit of Wachovia Corp. Lipton says that because of the lack of regulation, he refers clients to QIs that are affiliated with regulated entities.