1031 Advisor - July 2007

What is Your Fiduciary Responsibility to your Clients in a Section 1031 Exchange?

ONCE UPON A TIME . . . Qualified Intermediaries [the individuals that handle Section 1031 Exchanges] were often tax attorneys or real estate attorneys. These attorney Q.I.'s lived in the local community, had extensive knowledge of tax law (including federal tax law and Section 1031), and would guide the client and his or her advisor to properly structure the exchange. As a professional, the advice of the Qualified Intermediary could be relied upon and would provide protection from IRS penalties and interest. And everyone lived happily ever after.

Since that time, the Section 1031 Exchange industry has witnessed numerous changes. One change is market dominance by National 1031 Exchange Corporations. These Corporations will just as likely broker the purchase or sale of real estate¹, sell from their own real estate portfolios, including a Tenant in Common Properties, and provide mortgage financing; financial planning; deposit and savings accounts; estate planning and wealth advisory services; tax services and financial reporting; invest assets and establish a trust for the Exchange client. In short, they create a “One Stop Shop” for all your client’s current and future financial needs. How marvelous! Or is it??

Under the guise of providing “low fee” or “no fee” Section 1031 Exchange Services, these entities are building up their own businesses at the expense of your client’s assets.² No longer content to make a fair rate of return on loans or managing assets, these entities are manipulating the valuable financial assets that they control, including Exchange Assets, to create enormous wealth for themselves. Many of these companies routinely offer to share their commissions, finder’s fees and profits from the sale of other services to win over advisors and their clients. Their primary business duty is to make a profit for themselves.

National Banks are setting up Exchange Companies to bolster their financial assets, and several issues are arising in this process.³ First, Exchange Company Affiliates of Banks generally mis-classify these assets as long term core deposits, rather than short term funds deposited in their trust departments.⁴ These Exchange proceeds are lent out to borrowers and are used to boost their Parent Company stock valuations.⁵ Second, both recent scandals in the Exchange business concerning the potential loss of investor funds came from outside financial speculators who purchased existing Exchange Companies for the sole reason to profit from the manipulation of the financial assets.⁶

As professional advisors, what is our fiduciary responsibility to the client? We recognize that all sorts of advice is being provided by these Companies, who admittedly operate Exchange Services to funnel more customers into their other businesses. We also recognize that their advice is not always in the best interest of the client. Our fiduciary responsibility to the client is to read the fine print of the Section 1031 Exchange contract, and to recommend a qualified Q.I.

Our responsibility is to read the “fine print”. A closer inspection of the 1031 Exchange contracts with these Companies reveal that they owe NO duty whatsoever to you or your client, including errors, mistakes, loss of market value or loss of equity for assets purchased and potential loss of funds. As professional advisors, we know our duty is to our clients. A competent company will have confidence in their work and accept responsibility for their work product.

Our duty of care that we have when advising a client in a Section 1031 Exchange is to recommend a qualified Q.I. (Qualified Intermediary). How can this be defined? A qualified Q.I. can be defined as a person who provides the following NINE Services or Safeguards to the Section 1031 Exchange:

¹Some Intermediaries with real estate businesses offer commissions and other payments to non licensed customers and/or their advisors where their referrals lead to the sale of real estate or Tenant in Common sales, oblivious of the illegal nature of these payments.

²Deposits and other sources of funding make up a very simple, but important, piece of a bank’s operations. As financial intermediaries, banks are in the business of attracting deposits from individuals, business and other organizations and then lending these funds to customers with current credit needs. The bank’s ability to find deposits consequently plays a key roles in its ability to perform its banking functions. The Decline in Core Deposits: What can Banks Do? Federal Reserve Bank of Kansas City.

³In 1980 bank deposits made up 42% of all financial securities. By 2005, this had fallen to 27%. The capital markets increasingly perform the intermediation functions of the banking system. Financial Times June 19, 2007. The deposit side of the Bank is charged with raising funds that are then transferred to the lending side of the Bank. By establishing an Exchange Company affiliate, the Bank can dramatically reduce the cost of raising deposits at the nominal cost of providing free or lost cost exchanges. However, the assumption that seems to be ignored is that these same funds that are lent out over a period of years are due to be redeemed by the exchange client over a period of less than 180 days, and usually much shorter time period.

⁴Review of Annual Financial Statements of selected National banks with Exchange Affiliates indicates that the 1031 funds held by the Bank are treated as core deposits of the Bank. Core deposits are defined as those deposits that are expected to remain with a savings institution for a relatively long period of time. Such deposits are attracted by the convenience and service offered by the institution rather than from interest rates paid. While 1031 deposits can be held for as long as 180 days they are typically held for less than 3 months. The use of 1031 proceeds held on deposit permits Banks to artificially boost their stock valuations and use their stock to acquire other Banks or be acquired for higher values.

⁵Witness the recent 2.4 billion dollar payout to the founders of Blackstone Group after their blockbuster 4 billion dollar IPO on June 22, 2007. These gentlemen were managers of their client’s invested assets and profited by gathering in billions of invested assets.

⁶Southwest Exchange losses amount to 84 million dollars . 1031 Tax Group losses amount to an estimated 134 million dollars. This scenario is being played out by bank Affiliates which treat the funds as core deposits and these monies are lent out on a long term basis. However, these funds will be redeemed by the Exchange client in a period of less than 6 months. From a public standpoint, an even more pressing concern will be whether funding problems will keep Banks from meeting the credit needs of their customers and communities. The decline in Core Deposits: What can Banks Do? Federal Reserve bank of Kansas City.