Safeguarding Investors Utilizing 1031 Exchange AccommodatorsSeptember 20, 2007Taxation Committee Federal Issues Committee Commercial Investment Committee Legislative CommitteeThe following is forstudy only and has NOT been approved by the Taxation Committee, Federal Issues Committee, Commercial Investment Committee, Legislative or Executive Committees or the Board of Directors.Issue Should exchange accommodators be licensed and should financial protections to safeguard investors be required?Action Optional.Options 1. Sponsor legislation to license accommodators, as well as to require financial protections to safeguard investors (i.e., a fidelity bond, as well as errorsand omissions insurance).2. Support legislation to license accommodators, as well as to require financial protections to safeguard investors (i.e., a fidelity bond, as well as errors and omissions insurance).3. Support federal legislation to create financial protections that accommodators must take to safeguard investors and/or create national requirements for an accommodator’s license.4. Other.5. Do nothing.Status/Summary If a real estate investor utilizes a 1031 exchange, the profits from thesale of one property are directly used to purchase a second property and capital gains taxes are deferred until that property is sold. However, the business of 1031 exchange accommodators is largely unregulated at the federal and state levels of government with hundreds of independent exchange accommodators across the country. The California Legislature will consider a measure next year which currently requires the licensing of exchange accommodators, as well as requiring a fidelity bond anderrors and omissions insurance. Congress will likely move slowly on establishing regulations pertaining to exchange accommodators. At this moment, NAR is allowing the Federation of Exchange Accommodators (FEA) to make the first moves, but is keeping a close eye on their actions. Discussion In June, the C.A.R. Board of Directors approved the following motion:That the Taxation Committee recommends that C.A.R., in conjunction with NAR, look into the issue of accommodators/qualifiedintermediaries of 1031 exchanges and how to safeguard exchanging taxpayers and our industry members vis-à-vis the practice of accommodators/qualified intermediaries.The motion was the result of a resolution approved by the Santa Barbara AOR dueto losses sustained by some real estate investors using a local 1031 exchange accommodator.A 1031 exchange (so named because this type of arrangement is permitted by Section 1031 of the Internal Revenue Code) allows real estate investors to defer capitalgains taxes. If a real estate investor were to sell one property and then use the proceeds to purchase a second property he or she would have to pay capital gains taxes on any gain from the sale of the first property. However, if the investorutilizes a 1031 exchange, the profits from the sale of the first property are directly used to purchase the second property and capital gains taxes are deferred until the second property is sold (unless the second property is also exchanged for a third property, etc.).In a 1031 exchange, the investor has 180 days from the sale of the first property to find a second “like kind” property (e.g., real property can only be exchanged for real property, livestock for livestock, etc.). To defercapital gains taxes completely, however, the second property must be of equal or greater value than the first property; otherwise, the difference in values between the two properties will be taxed. In addition, the investor can not receive the proceeds from the sale; instead, the funds must go into an account maintained by an exchange accommodator (also known as a “qualified intermediary”). It is at this point in the transaction that an investor’s funds can become vulnerable.In March, a Santa Barbara law firm filed a lawsuit charging two exchange accommodators, Qualified Exchange Services and Southwest Exchange, of stealing more than $95 million from 130 investors in 12 states. And, in May, 1031 Tax Group LLC filed forbankruptcy protection owing an estimated $151 million to over 300 investors across the country. In addition to having lost their money, these investors also face having to pay capital gains taxes because they failed to meet the 180 day exchange deadline.While many exchange accommodators are part of a bank or title insurance company, the business of 1031 exchange accommodators is largely unregulated at the federal and state levels of government with hundreds of independent exchange accommodators across the country. Nevada is the only state that specifically regulates exchange accommodators; Idaho has an escrow law which the state finance director has opined applies to exchange accommodators. As a result of the recent incidents involving exchange accommodators, the California state legislature will be considering legislation next year to address this issue.(It should be noted that there are some steps that real estate investors can take to protect their funds. Key among these is to make sure that their funds are kept in a segregated account and not co-mingled with other funds being held by the exchange accommodator. Moreover, the investor should insist that he or she be one of the required signers on the account maintained by the exchange accommodator.)In late May, state Senator Mike Machado “gutted and amended” his Senate Bill 1007 to require the licensing of exchange accommodators. According to staff to the Senator, the current contents of the bill should beseen only as a starting point for discussions which will take place during the fall. Currently, in addition to requiring licensure, the measure would require a $1 million fidelity bond against which investors sustaining damages can file a claim. In addition, exchange accommodators would be required to maintain errors and omissions insurance of not less than $250,000.While the Commissioner of Corporations would be authorized to examine the records of the exchange accommodator, there is no requirement in the bill that the existence of the fidelity bond be confirmed on a regular basis. Also, the measure does not contain any penalties beyond license suspension for failing to maintain the fidelity bond. More importantly, given the incidents described above, it is questionable whether a $1 million bond is sufficient.Congress is reluctant to enter into this arena as the problems have not yet been seen extensively across the country. In addition, Congress traditionally prefers to first give the states an opportunity to respond to such public policy problems. By way of example, given the extent of the recent subprime lending problems that have occurred nationwide, Congress is just beginning to act, as they waited to see if private associations, the states, and regulators could address the problem before Congress was forced to intervene. It is likely that Congress will take the same approach with exchange accommodators, giving the states and the accommodators’ governing body time to reform or reinforce, respectively, their licensing requirements and internal guidelines before stepping into enact federal legislation. However, Congresswoman Eshoo is following the issue and, if she feels a national response is necessary, has indicted she may author a bill addressing this issue.Nonetheless, NAR is currently working with FEA, which is the governing association for many of the accommodators. FEA is working with the IRS and seeking relief for those taxpayers unable to satisfy the 180-day test because of the failures of the accommodators. FEA is also looking to tighten their guidelines and set new requirements for accommodators. NAR will have another meeting with the FEA before their November meetings. Additionally, NAR has formed an internal and informal task force that will explore issues such as risk management for real estate professions who make accommodator referrals, new disclosure requirements for accommodators, increased fiduciary standards and whether these reforms need to be done on the state or federal level. C.A.R. expects an update from NAR during the November meetings in Las Vegas.A final note: Any federal legislation would likely pre-empt state laws, which C.A.R. has historically opposed.