September 22, 2008

Taxation Committee
Legislative Committee

The following is for study only and has NOT been approved by the Taxation Committee, Legislative or Executive Committees or the Board of Directors.

Issue
Should 1031 exchange accommodators be regulated as escrows?

Action
Optional

Options
1. Sponsor legislation. Statutorily provide that exchange accommodators come within the definition of an “escrow” and, as such, are required to be regulated by the Department of Corporations.

2. Request opinion. Submit a request to the state’s Attorney General for a legal opinion that determines whether exchange accommodators come within the current statutory definition of an “escrow.”

3. Do nothing. Generally, state law currently generally requires only that exchange accommodators maintain a $1 million fidelity or cash bond.

4. Other.

Status/Summary
If signed into law by the Governor, SB 1007 (Machado) would provide some protection for real estate investors given the requirement for a $1 million fidelity bond or $1 million in cash, securities or a letter of credit. However, given the tens of millions of dollars involved in the two notorious 1031 exchange accommodator cases that occurred last year, the adequacy of SB 1007’s financial responsibility requirement has rightly been called into question. It may be possible to provide greater regulation of 1031 exchange accommodators by bringing them under California’s Escrow Law. 1031 exchange accommodators appear to be very similar to escrow companies in that they hold funds for the purchase of a property. While the bond amounts that each escrow company must maintain under the state’s Escrow Law are significantly lower than that required of exchange accommodators by SB 1007, membership in the Escrow Agents’ Fidelity Corporation would provide significantly greater financial security for real estate investors.

Discussion
A 1031 exchange accommodator (so named because this type of arrangement is permitted by Section 1031 of the Internal Revenue Code) allows real estate investors to defer paying capital gains taxes. Generally, if a real estate investor sells one property and uses the proceeds to purchase a second property he or she will have to pay capital gains taxes on the gain from the sale of the first property – which could make purchasing the second property difficult if not impossible. However, when the investor utilizes a 1031 exchange accommodator, the proceeds 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.

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 receive in exchange. (In a 1031 exchange, a property is not “swapped” directly for another property. Generally, the real estate investor sells his or her property to a purchaser and buys a different property from another seller.) To defer capital gains taxes completely, however, the second property must be of equal or greater value than the first property; otherwise, the difference in value between the two properties will be taxed. In addition, the investor can not receive the proceeds from the first 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 sometimes become vulnerable.

In March last year, 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 2007, 1031 Tax Group LLC filed for bankruptcy protection owing an estimated $151 million to over 300 investors across the country. As a result of the recent incidents involving exchange accommodators, the California state legislature considered and approved legislation intended to provide some protections to real estate investors.

If approved by the Governor, Senate Bill 1007 (Machado) will require exchange accommodators to comply with one of the following: (1) Maintain a fidelity bond of at least $1 million, (2) Deposit an amount of cash, securities, or irrevocable letters of credit of at least $1 million, or (3) Deposit all exchange funds in a escrow or trust and provide that any withdrawals from those accounts require the exchange accommodator’s and the real estate investor’s written authorizations. (Note: The required monetary protections are per exchange accommodator, not per transaction.)

SB 1007 would provide some protection for real estate investors given the requirement for a $1 million fidelity bond or $1 million in cash, securities or a letter of credit. However, given the tens of millions of dollars involved in the two notorious 1031 exchange accommodator cases that occurred last year, the adequacy of SB 1007’s the financial responsibility requirement has rightly been called into question.

It may be possible to provide greater regulation of 1031 exchange accommodators by bringing them under California’s Escrow Law. The Director of Finance for the state of Idaho has opined that 1031 exchange accommodators by virtue of holding significant amounts of money in escrow come under that state’s escrow law. Exchange accommodators generally only hold the proceeds from the sale of the relinquished property; those proceeds are used to purchase the replacement property for the real estate investor. The exchange accommodator at no time holds title to the relinquished or replacement properties. As such, 1031 exchange accommodators indeed appear to be very similar to escrow companies which simply hold funds for the purchase of a property. 1031 exchange accommodators, instead, hold funds for the exchange of one property for another.

California’s Escrow Law provides, in part, that an “escrow” means “any transaction in which one person [the seller], for the purpose of effecting the sale … of real property to another person [the buyer], delivers … evidence of title … to a third person [the escrow company] to be held … until the happening of a specified event [the buyer providing the money for the purchase of the real property to the escrow company] … when it [title to the property] is then to be delivered by that third person to the [buyer].” While this definition covers the typical purchase of real estate, it also appears to encompass 1031 exchange transactions.

Under California’s Escrow law, escrows are required to be licensed by the Department of Corporations. Among the requirements for licensure are: (1) membership in the Escrow Agents’ Fidelity Corporation, (2) a fidelity bond of not less than $125,000, (3) liquid assets in excess of current liabilities of $25,000 and tangible assets in excess of total liabilities of $50,000, (4) a surety bond of $25,000, (5) background checks of all stockholders, officers, directors, managers and employees, and (6) a manager who possesses a minimum of five years of responsible escrow experience.

While the bond amounts that each escrow company must maintain under the state’s Escrow Law are significantly lower than that required of exchange accommodators by SB 1007, membership in the Escrow Agents’ Fidelity Corporation would provide significantly greater financial security for real estate investors. Coverage of up to $5 million per escrow company location is required for monthly escrow liability of up to $10 million per location. And, if monthly escrow liability exceeds $10 million for an escrow company location, the company must obtain a surety bond in a ratio of one dollar of coverage for every three dollars of trust obligations not covered by the Fidelity Corporation.

While legislation could be sponsored to make it clear that 1031 exchange accommodators come under the state’s Escrow Law, an alternative would be to request a legal opinion of the state’s Attorney General as to whether, in fact, 1031 exchange accommodators already come within the state’s Escrow Law. The advantage of this approach would be that C.A.R. resources would not have to be devoted to securing approval of legislation or, at least, not devoted to such an endeavor until it was clear that legislation is necessary.