1031 Tax Deferred Exchanges are wonderful when they work, but we've just learned of a financial disaster and believe everyone needs to take note.
Simply put, a 1031 Tax Deferred Exchange is a mechanism whereby a real estate investor can roll over the cost basis from one investment property to another and defer paying capital gains taxes until the last property is sold and cashed out. In a transaction, a third party "qualified intermediary" ("QI") holds the funds from a sale until a new purchase is made following strict IRS guidelines. The QI then pays out the funds for the purchase and receives a fee for their services. The problem is, the industry of exchanging is not regulated, and here's what happened to clients of The B&B Team.
They sold their inn. Proceeds of sale went to a qualified intermediary per the rules. They had 45 days to designate new investments and 180 days to settle. After 45 days they hadn't found a property to buy, so they asked for their funds back, only to discover that there was no money! "It seems that he [the QI] invested client funds in Lehman Brothers auction rate securities probably as long as a year ago. When that market froze, he started funding exchanges with new client money (otherwise known as a Ponzi scheme). By the time we were to be funded, there wasn't any cash left."
This is an unmitigated disaster for these folks, and apparently there are a number of exchange companies recently that have filed for bankruptcy, so others have been hurt by similar schemes and problems. But don't throw out the baby with the bath water. There is a solution to protect yourself.
Our client goes on to say, "If someone wants to do a 1031, they need to make sure that the agreement states that their funds are to be kept segregated in an account in their name (very important) and that they specify how the funds are to be invested. In addition, they need to make sure they get copies of the bank statements. If the amount is more than FDIC covers, they might want a surety bond for the difference." To support this, our client adds that "The only one getting their money back so far is someone who did the above. The court ordered an immediate release of their funds."
In a time of greed and uncertainty, there seems to be no shortage of unscrupulous people. But bad behavior doesn't make a system wrong. It's people who are flawed, and people who can learn lessons. We hope you'll make note of this warning and advice about 1031 exchanges, so you can both take advantage of the great tax benefits inherent in them and protect your assets in the process.