“Safe Harbor” May Not Be Safe After All
July 20th, 2009 | 
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Back on November 26, 2008, LandAmerica Financial Group, the third largest 1031 exchange intermediary at the time, filed for bankruptcy protection. Its subsidiary, LandAmerica 1031 Exchange Services (LES) filed for voluntary relief under Chapter 11 of the bankruptcy code. At the time, LES was the intermediary for over 450 incomplete transactions.
With a recent ruling by a U.S. Bankruptcy Court in the case of Millard Refrigerated Services vs. LandAmerica 1031 Exchange Services, any seller might now risk having some or all of their money completely out of their control if it was set aside with an intermediary for a tax-deferred exchange. 1031 intermediaries were once known as “safe harbors”, essentially as a safe place to dock one’s proceeds from a sale until they could find another property with which to use the funds to buy, thus completing their 1031 exchange, and protecting their capital gains from being taxed by the federal government. Well apparently, these safe harbors ain’t so safe anymore.
One of the big issues in this case was the terminology used in the agreement, something that might be looked over by a seller in a rush. There was nothing that spoke of a trust, trustee or beneficiary. While you can use a trust as your “safe harbor” when doing a 1031 exchange, the more common route is to simply use a “qualified intermediary,” which LES was. The issues in that instance, is that there is no control over how the qualified intermediary invests those funds. Because of that simple but glaring oversight, the bankruptcy court ruled that the funds were not trust funds, but rather part of the bankruptcy estate of LES, making the seller simply another creditor.
What a nightmare for the seller in this instance. That being said, there are pretty simple ways to protect yourself from this type of debacle in the future. First and foremost, as we’ve all learned from the stock market, is to diversify. If you are an active investor with multiple properties in a 1031 exchange, resist the temptation to continually use the same company just because you like them. It protects a bad day from turning into a nightmare for your portfolio in case the company files bankruptcy. Also, make sure to specify exactly how the money will be handled by the intermediary. By taking the time, you will better ensure that your funds are protected. Might it increase the complexity and cost of the transaction. Absolutely. But is it worth the risk not to? Absolutely not.
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I take issue with your statement that “any seller might now risk having some or all of their money completely out of their control if it was set aside with an intermediary for a tax-deferred exchange.” Prudence dictates that investors and their advisors ask questions, not only of 1031 exchange companies, but of any firms with whom they deal. As the Millard v. LandAmerica case points out, there were some very basic flaws in LES’s business model. First, taxpayers signed over all “right, title and interest” in their exchange funds. Second, there was no express statement that the funds were being held in escrow or in trust. Third, LES pooled funds from multiple taxpayers, and comingled those funds with its own operating funds. These three factors brought the Millard firm to its knees.
For investors contemplating a 1031 exchange (and their advisors), there is now clear guidance: demand that the funds be held in escrow or in trust, that the documents clearly reflect this status, and that all funds be held in truly segregated accounts. The best Qualified Intermediaries (QIs) are already doing this, and have no hesitation respond to such requests.
Further, QIs who are members of the Federation of Exchange Accommodators (FEA), adhere to a strict Code of Ethics that: prohibits comingling of taxpayer funds with QI funds; mandates that all funds be held in a qay that preserves liquidity; and prohibits the loaning of taxpayer funds to the QI or anyone related to the QI.
Avoiding repeat business with the same QI has no bearing on whether the QI adheres to these strict standards, both as set forth in the FEA Code of Ethics, and as dictated by the Millard decision. In fact, once a taxpayer has found a reputable QI who follows these rules, there is no reason to go elsewhere.
David…I agree with most of your argument. my broader point in writing this post was that people who didn’t read the fine print the first go-around are paying the price. i do feel that i used enough qualifiers in the quoted sentence to alleviate me of a making a hard and fast definitive statement….at any rate, thanks so much for your comment and insight.
David,
As a victim of Ed Okun’s criminal defrauding of the various 1031’s he acquired, I thought your initial post was right on target…but would add that there needs to be required a counter signature of the exchanger (or his/her designated representative) to move the funds — ideally, that requirement, being formalized with a signature card signed by an official of the bank holding the exchange funds (to ensure the bank’s own liability if the funds are improperly moved). The overriding problem, of course, is the TOTAL lack of regulation, accountability, oversight, reporting or criminal liability or penalty in the event the QI mishandles or absconds with your exchange funds.
As to the totally worthless FEA — please note that ALL of the QI’s secretly acquired by Okun were and remained members in good standing of the FEA even as they were cavalierly surrendering all of their exchange deposits to him, that the only action by the FEA in response to his criminal activity was to quietly delete those QI’s (and the others that have similarly failed taking exchangers’ funds with them) from their membership roster — In fact, Todd Pajonas, former owner/CEO of Security 1031 Services and an officer of the 1031 Tax Group who collaborated with Ed Okun and testified under immunity at his criminal trial as since opened ANOTHER QI, hilariously and ironically named “LEGAL 1031 Services” (in apparent sharp contrast to his previous forays into the 1031 business?) and remains to this day a member in good standing of the FEA according to their website. In sum, FEA membership means absolultely nothing in terms of assurances of integrity, security or even past business practice!