Trouble for some tax-deferred 1031 exchanges

I’m a pretty plain vanilla investor, and it’s situations like those detailed in a recent Bloomberg story on 1031 exchanges that keep my market maneuvers simple.

Before getting to the news story, let’s detour just a minute to look at 1031 exchanges. These transactions are named for the tax code provision that allows for the deferral of capital gains taxes on business or investment property that is exchanged for a similar property. You also might have heard them called like-kind or, if you’re a seasoned (sounds better than "old," don’t you think?) tax watcher, Starker exchanges.

Please note a few key words in connection with the process.

First, "business or investment." The properties involved in the swap must be, according to tax law, "held for productive use in a trade or business, or for investment." So you and a friend can’t trade your homes that are worth more than your residential sale exclusion and avoid, at least for a while, taxes on the transaction.

Next, "exchange." My swapping example above was for illustrative purposes only. You don’t actually trade properties in the conventional sense of the word. You typically sell your first one, then use those proceeds within a specified time to buy another property.

Then there’s the very important "deferral." That’s right. You don’t escape the taxes. You just get to delay them until you ultimately sell the property that you acquired in the exchange.

Finally, we have "similar." Simple, right? But remember, it’s tax law we’re talking about, so this usually straightforward word gets a bit more complicated.

Take, for example, the IRS discussion of this issue:

Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.

Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.

Confused? Me too. So I did little more surfing and found, over at the Federation of Exchange Accommodators (the Professional Trade Association for Qualified Intermediaries under IRC §1031), that "all qualifying real property [i.e., real estate] located in the United States is like-kind."

Once you’ve worked out the property similarity issue, then you have related party restrictions and holding period limitations, not to mention all the different types — simultaneous, delayed, build-to-suit, personal property and reverse — of exchanges.

Intermediary irregularities: Whew! That’s why you definitely need professional guidance in the 1031 exchange arena. And the transactions also must be handled by qualified
intermediaries.

According to the previously mentioned Bloomberg story (see, I finally made it back there), "Exchange companies became popular during the mid-1990s after Congress streamlined the deferral law. They typically charge fees of about $500 to $1,500 per transaction and take a share of the interest earned on the money they’re holding. Some are paid incentives by banks for opening new accounts."

Unfortunately, not all exchange companies are of similar quality. And that’s caused some major problems for folks who thought they were making tax-smart financial moves.

The Bloomberg article looks at investors who’ve lost the proceeds of their property exchanges because the 1031 companies that handled them went bankrupt. Owners of the bankrupt firms, says the news service, are accused of using client funds to invest in other businesses, emptying bank accounts of more than $250 million. Investigations are underway, but no criminal charges have been filed.

Meanwhile, in the wake of the collapse we have the inevitable lawsuits that are trying to recover the losses. Investor claims range from tens of thousands of dollars to more than $20 million.

The situation also has prompted calls for oversight of 1031 intermediaries, an industry in which the the property middlemen have temporary custody of about $150 billion a year, but is unregulated everywhere except Nevada. One of the firms now in question, however, is based in the Silver State, which has since increased its supervision of such firms.

Like I said up front, while things like 1031 exchanges are intriguing with their possibilities of big bucks, our nest egg is doing OK with our real estate investments limited to a REIT fund. And, particularly in light of the issues raised by the Bloomberg piece, I’m sticking to that basic investment strategy.