Investor Report: Lack of Regulatory Oversight

For the second time in two months, federal authorities have warned real estate investors about the lack of regulatory oversight of so-called “qualified intermediaries” in tax-deferred Section 1031 exchanges.

The latest advisory comes from the Treasury Department's inspector general for tax administration, whose audit documents the boom in real estate exchanges -- more than a doubling in five years to 429,000.

In tax year 2005 alone, according to the Treasury report, a record $101.3 billion in otherwise taxable real estate gains were deferred through 1031 swaps.

Qualified intermediaries are used in most of these transactions as middlemen -- receiving and holding the proceeds of the exchanges and then disbursing funds.

Under the tax code, owners of investment real estate can exchange them without immediate taxation of gains if the properties involved are “like kind” and the transaction meets other requirements.

The vast majority of exchanges are conducted without significant problems, but a small percentage have experienced costly abuses by intermediaries who violate the trust of the participants and dip into escrowed funds for their own use, or run away with the money outright.

In recent years, according to the Treasury, there have been 23 instances of major fraud involving $250 million in estimated losses. These have often been catastrophic for the parties to the transactions, sometimes forcing exchangers to get hit with large tax bills from the IRS.

The Treasury report noted -- as did an earlier advisory from the Federal Trade Commission -- that there is no direct federal oversight of 1031 exchanges, and minimal to no oversight by most states.

The IRS monitors the tax aspects of exchanges, whether, for example, the parties identified replacement properties within time limits, and properly structured the transactions to comply with IRS rules.

But the IRS does not oversee the various participants in exchanges.

Given the huge recent growth in 1031 deals, the Treasury inspector general urged the IRS to increase its efforts to alert real estate investors about the potential risks of using intermediaries, and to publicize other alternatives available to exchangers, including standby letters of credit and third-party guaranty arrangements.

The IRS promised it will do so.

Bottom line if you are contemplating a 1031 transaction: Listen to the Treasury on this. Use the most experienced, heavily-vetted intermediaries.

Or check in with the IRS and take a hard look at the alternatives.

Written by Kenneth R. Harney for www.RealtyTimescom. Copyright © 2007 Realty TimesAll Rights Reserved.