THE FUTURE of The 1031 Exchange Industry

So far in 2007, there have been three spectacular 1031 intermediary defalcations: Southwest Exchange of Henderson, Nevada ($100 million), Scoop Daniel of Breckenridge (the attorney that took one million and disappeared), and IXG (locally) and its related companies ($150 million).

All of these problems arise from two systemic problems with the industry: first of all there are no entry barriers to become an intermediary. Both Southwest and IXG were existing intermediary companies that were purchased by people who had no intermediary experience and whose sole intention for purchasing the company, apparently, was to get control of the exchange balance. Locally, Mile High Capital from last year is another example of this problem because according to several press reports they set up their own intermediary company and hired a convicted felon to run it.

Secondly, there are no controls on what intermediaries can do with the exchange proceeds while they hold them. All of the problems we’ve had with bad intermediaries involve commingled accounts where the intermediary has placed all of the exchange proceeds into one commingled, or pooled, account, rather than in a separate, or segregated, account for each client.

...the new law provides a pretty good road map of where Colorado is likely to go...

So, what does the future look like for the 1031 exchange industry? Will Congress do away with Section 1031? Will it be re-written to clamp down on exchange intermediaries? And what role will the states, like Colorado, play in all of this?

First of all, Congress will not do away with Section 1031. They have done a number of cost/benefit studies, and all of them conclude that they collect more taxes with 1031 exchanges than they would without. And it would make sense that Congress would amend the code section to clamp down on intermediaries, but given all of the other issues that Congress is faced with right now, including the war in Iraq, this issue is pretty small potatoes to them.

Colorado is much more likely to enact laws regulating intermediaries. Nevada just imposed a new law in reaction to the Southwest Exchange mess, and their law provides a pretty good road map of where Colorado is likely to go. First of all, the Nevada law requires intermediaries to be licensed, including new owners when an intermediary is sold. While this wouldn’t have protected the public from Scoop Daniel (because he was an attorney), it would have protected us locally from the IXG buyer and from the intermediary portion of the Mile High mess because a background check is required and you have to show knowledge of, and experience in, the 1031 industry.

The Nevada law most heavily regulates how the clients exchange proceeds are held. It requires two signatures to withdraw money from the account (the client’s and the intermediary’s); this implies that you must park the money in a segregated account for each client, although my banking friends tell me that it is theoretically possible to have a pooled fund with two signatures required for each withdrawal. That sounds like a logistical nightmare to me; wouldn’t it just be easier to have segregated accounts?

The Nevada law also requires the state banking commission to audit the intermediary not less often than every five years. That implies to me that the funds have to remain within Nevada because I doubt that they’re going to fly all the way to Denver to audit my account, and what are they going to audit anyway – all of my exchanges, or just my Nevada exchanges? Having all of the money from that state’s exchanges be held in the state would solve a lot of audit problems.

The Nevada law also requires the intermediary to post a fidelity bond and to carry errors and omissions insurance. This will be the kiss of death for small intermediaries since this insurance will be very expensive, if the intermediary is able to obtain it at all.

So, looking into my crystal ball, this is what the intermediary industry will look like in Colorado in a couple of years: intermediaries will be regulated by the Colorado banking commission. We’ll have to be licensed, which will require a background check and proof of competency. We’ll have to keep each exchange account in a segregated account, which will require two signatures, and the account holding Colorado exchange funds will have to be in a Colorado financial institution. Fidelity and errors and omissions insurance will be required.

The end result is that most, if not all, small “mom-and-pop” type intermediaries will disappear; even some of those owned by title companies. Costs for intermediaries will sky rocket and revenue will shrink which means that fees will increase dramatically and your choices of intermediaries will diminish as well (you won’t be able to shop around for lower fees).

On the plus side, the intermediaries that survive will do so providing a superior level of service and the technical level of intermediary work will increase accordingly. And best of all, your money will finally be safe.