Today, many investors often trade their investment properties to avoid paying federal and state capital gains taxes. This 1031 exchange often requires the involvement of a qualified intermediary or 1031 exchange company to avoid constructive reception. Otherwise, your transaction may not qualify for the tax-deferred 1031 exchange. The exchange company will hold all money from the relinquished property for up to 180 days while it searches for a replacement property to complete the exchange. Many investors are unaware that these companies are in a business that is not regulated by the federal government or any of the 50 states. There have been petitions over the years to the Federal Trade Commission (FTC) to regulate the industry. However, the FTC rejected the petition in August 2008. This means that these exchanges can use your money to invest in whatever they want. They do not need to disclose where they invest, what they invest in, or the risks of their investments. On September 30, 2008, the State of California passed Senate Bill 1007 which provided some consumer protections for 1031 exchange investors. This bill prohibits exchange companies in California

1. Soon to exchange funds with the company’s operating accounts.
2. Investing exchange funds in a way that does not provide sufficient liquidity or preserve principal.

There have been sad stories about exchange companies losing investor money on risky investments and then going bankrupt. Investors can only get a fraction of their money back. On top of that, they may have to pay capital gains tax because they don’t complete the transaction within 180 days. For example:

• On November 26, 2008, LandAmerica 1031 Exchange Services, a subsidiary of LandAmerica, a major provider of title insurance company, Landam.com, filed for Chapter 11 bankruptcy protection. Investors had more than $400 million in dollars deposited with the company, but its auction-rate securities were illiquid and worth much less.
• On December 15, 2008, the Summit 1031 Exchange, Summit1031.com, announced that it stopped funding all existing accounts. Their account balances were less than the $24.8 million deposited by investors. The author knew an investor in San Jose who put more than $2.5 million into this company. As of March 2009, he was able to recover just over $625K. How much more you can recover depends on the outcome of the liquidation of your assets.

So the risks are very real and they can happen to anyone. How to avoid being a victim? To answer this question, you will need to understand a bit about the exchange business. Most exchange houses make money by charging a transaction fee. They, in turn, invest your money somewhere with higher returns, pay you low interest of .5-1%, and pocket the difference. This is how exchange houses normally make most of their profits. In LandAmerica’s case, it put much of customer money into high-yield auction-rate securities backed by federally insured student loans. However, these securities have become very difficult to convert into cash due to the tight credit market. LandAmerica had to sell these securities for less than the value of the securities when exchange customers need money to complete the exchange. As a result, he did not have enough money to cover his obligations and had to declare bankruptcy.

There are 3 main types of exchange companies:

1. Some exchange companies are just a division or subsidiary or an entity owned by an escrow or title insurance company. For example:

• First American Exchange Company (FAEC), is a separate limited liability company (LLC) owned by First American, which is also engaged in the title and escrow business. FAEC occupies the same office and even has the same phone number as the First American Title office.
• Old Republic Exchange, is a member of The Old Republic Title Insurance group.

• IPX, Inc.
• Equity 1031, LLC.
• Equity Preservation, Inc.

The fees these companies charge range from $200 to $750 per transaction. However, there are different restrictions:

1. The company that charges a low fee often pays no interest on your fund or only pays interest if your fund is above a certain amount. If the proceeds of your sales are significant, say several hundred thousand dollars, you may save on fees but may lose a significant amount on interest payments.
2. Some companies charge higher fees, for example First American Exchange charges $750, but can allow you to make as many offers as you want. Each time your offer is accepted, the exchange must review the contract and transfer the money to the seller’s escrow account.

During the economic downturn, many large companies faced heavy losses and went bankrupt. You must choose a broker in 2 factors

1. The most important factor is which company can provide security and timely disbursement of your funds. When the amount of money is substantial, say several million dollars, this is even more critical.
2. Fees, interest rates and staff competence should be a distant secondary requirement.

To make sure your money is safe, you should ask the exchange company if

1. Your money is insured by the FDIC (Federal Deposit Insurance Corporation, a US government corporation created by the Glass-Steagall Act of 1933). When it comes to deposit insurance for your bank accounts, FDIC insurance probably provides the best protection for your money. The account is insured up to $250K per client. So if the exchange account is in the name of the husband and wife, it is insured up to $500K. When you have more than $500,000, you want the bank to deposit your money into a Certificate of Deposit Account Registration Service, or CDARS account. Your money is deposited in multiple banks to be insured up to $250K per client per bank up to $50M. The CDARS account is a CD account, so you probably want a short-term CD to make sure you don’t pay an early withdrawal penalty. A broker may advertise that he is carrying $100 million in fidelity bond. However, this bond is intended to protect the company against theft or embezzlement, not investment loss. You can also say that your account is secured by the assets of your publicly traded parent company. However, this guarantee does not mean much if the company has more liabilities than assets.
2. Your money is deposited into the (next) operating account or a separate account in your name. When the money is in the trading account, the exchange house can use it for anything; for example, paying the salary of your employees or investing in the stock market in China. In addition, the money in the trading account belongs to the company. If the company files for bankruptcy, it is more difficult to prove whether the money in the account is your money. On the other hand, the separate account is your account to keep your money for your own use. If the business files for bankruptcy, it’s easier and faster to get your money back from your separate account. Just because your money is in a separate account doesn’t make your money any safer, it just makes it easier and faster to claim it’s your money. Normally if you don’t say anything, your money is deposited in a general account.
   • The separate account is called a trust account if the exchange company is a subsidiary or division of a bank. The account name should be something like “John and Jane Smith Trust Account” with their tax ID. This trust account is regulated by the government and the exchange company cannot use money for its business.
   • The separate account is called a segregated account if the exchange company is a subsidiary or division of a title company. The account is in your name and tax identification number. This account is not regulated by the government. The exchange company can still invest in the same way as other non-segregated accounts if you do not specify anything.
3. Where your money is invested, eg money market. Again, since this is an unregulated business, you don’t need to provide it with a prospect and you don’t necessarily need to invest where you say you do. If the money is invested outside of the US, where you probably don’t know it, there may be a delay from the time you request your money to the time you actually receive it.

Conclusion– When you choose an exchange company, you should consider their fees, services, and most importantly, the safety and timely disbursements of your funds. You should consider an exchange broker located in California where your account is FDIC insured.