Disqualified Intermediaries - When 1031 exchanges go horribly wrong

How can a 1031 exchange company management pay for the operation of a Bombadier Challenger exec jet, with global range, $3000 rooms at Hotel George Cinq and other world class hotels, a $1000+ meals nearly every night, expensive mansions and a Mercedes 600 S for their former investment manager from Smith Barney?

Simple: Use clients’ money held in 1031 escrow accounts. This is what the management of now defunct Southwest Exchange Inc. is alleged to have done. To the tune of some $83,000,000, and climbing, in missing investor funds. The FBI is now involved.

The 2004 buyers of this formerly respected company worked out that on deposits of $100 million or so, only $30 million was on call at any one time. The difference appears to become a personal slush fund for McGhan family.

Unregulated Funds

As tax deferral strategies grow ever more popular through the use qualified intermediaries, administering 1031 exchanges, vast amounts of money is held in trust for clients using these tax deferral techniques. Trustworthy performance is a minimum standard for these intermediaries. They hold investors’ money in trust between transactions ensuring the proceeds are held at arms length from the investor and therefore meet IRS tax deferral standards.

The sale of most property creates a profit. To avoid paying taxes, this money is held until the seller, now buyer, identifies, buys and closes on the next property within the specified 180 day period. If the money is reinvested in a qualified property, any applicable tax is deferred to a future time.

During this period of up to six months the money is essentially idle in escrow with the QI. These companies are mostly unregulated. As a Nevada based exchange company, Southwest Exchange was required to register, and post a $50,000 bond, with the Nevada Real Estate Division.

1031 exchange intermediaries or accommodators make their money from fixed fees and any interest spreads between the interest paid clients versus the interest earned on the collective client funds on deposit in their escrow accounts.

Banks Without Walls or Vaults

Says California class action expert, Robert Brace, “if someone robbed a bank of $100 million it would make front page news. Because it happened in an archane corner of real estate only the affected investors seem to care.” Says Brace, “when the IRS created this tax fiction, they created it in a regulatory vacuum. There are so many mom and pop stores operating as QIs and no one seems to be watching.”

The class action complaint claims a group of thieves, lead by the jet setter Donald McGhan and his family, discovered that these QI exchange accommodators were unregulated businesses holding large sums of cash. Only a small percentage of the money held by the QI is needed to operate the company as a going concern.

Class action litigation expert Brace is looking for others who have been damaged by this theft. Brace can be reached at Hollister & Brace, Santa Barbara, California 805-963-6711 or rlbrace@HBSB.com. This is not unusual. In 2006 Mile Hile Capital and their 1031 scam partner Replacement Property Solutions, Inc,., lead by a convicted felon, were caught effectively funneling money from unsuspecting investors into personal uses.

New Policy Born of Last Crisis

Not only have these investors lost their investment, but they may also face adverse tax consequences, said David Turner, a Reno-based certified public accountant with Turner, Loy & Co.

“The investor test for a qualified 1031 intermediary is simple,” says a1031 industry expert, does the intermediary commingle all investor funds in a single account or open individual escrow accounts for each investor? Banks do this as part of their fiduciary relationship with customers, so should we.”

Why are individual accounts important at a QI:

1. So an investor see exactly where their funds are?
2. So any regulatory body can walk in and within an hour see where the money came from, where its held on trust for a client and match these accounts with bank records.
3. When funds are commingled, they are now deemed to be property if the QI company, not the individual investor.

This means in the event of a judgment (civil or criminal liability or bankruptcy,) these funds can be seized as assets of the intermediary company without regard for any claim by the individual investor.

4. What is their reputation and stature in the industry?

In the case of Southwest, the Founder Betty Kincaid sold management control to the McGhans without customary due diligence in selling a business based on trust, and only realized something was wrong after her hard won reputation had been used to allow the sham flourish.

5. An investor should not simply rely on a 1031 referral from a real estate professional but conduct personal due diligence before selecting a QI.

There are similar concerns over the custodial and administration companies in the self directed IRA market, who also operate in an equally loosely regulated environment.

Blood in the Water

We suspect every real estate agent and broker who recommended Southwest Exchange as a QI going to be targeted. Real estate professionals and brokerages have deep pockets and lots of insurance. They also have a habit of quickly paying off any claims to avoid suggestion of any apparent professional lapses. We suspect with number and power of the legal hyenas circling this carcass, it’s will be a feeding frenzy. If you are a real estate agent that recommended SW as a QI, Brazil looks good.

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