Don't Use Commingled 1031 Accounts When Investing in Real Estate - dummies

Don’t Use Commingled 1031 Accounts When Investing in Real Estate

By Eric Tyson, Robert S. Griswold

Copyright © 2015 Eric Tyson and Robert S. Griswold. All rights reserved.

Leading 1031 exchange accommodator LandAmerica’s November 26, 2008, bankruptcy filing should alert all real estate investors to the real perils regarding what firm they choose for handling their 1031 exchange and holding their funds. In the case of LandAmerica’s Exchange Services Company, the company held hundreds of millions of dollars from more than 400 real estate investors. Unfortunately for real estate investors using LandAmerica’s 1031 Exchange Services (LES), their funds were placed into a pooled or commingled account and got caught up in the parent company’s bankruptcy filing.

LandAmerica got itself into trouble by investing this commingled money in 20-year maturity auction rate securities backed by student loans. In the past, there was an active liquid market for these securities, so LandAmerica was able to pocket millions of dollars in interest investing its 1031 customers’ money. Because of the turmoil in the financial markets during 2008, the market for auction rate securities dried up and pushed LandAmerica into bankruptcy. LandAmerica could have avoided this by having all its customers use separate or so-called segregated accounts titled something like “for the benefit of Joe Property Investor” in an FDIC insured bank. This precaution would have protected the customers’ money from bankruptcy, lawsuits against the exchange accommodator or parent company, and so on.

LandAmerica isn’t the first 1031 exchange company to take client money down with the company. 1031 Tax Group, a Richmond, Virginia–based 1031 accommodator, and Southwest Exchange of Henderson, Nevada, both went under in 2007 with possible fraud involving more than $200 million missing between these two companies.

So how could this kind of thing happen, especially after Fortune magazine named LandAmerica its number one most admired company in the mortgage services industry in 2007? 1031 companies are unregulated, and few people understood the risks of companies like LandAmerica putting customers’ funds into commingled accounts. Plus, some 1031 accommodators quote lower transaction-handling fees and then make up for that lower fee by gaining investment interest on a customer’s funds.

You can take a few steps to help ensure you don’t end up in this kind of situation. First and foremost, conduct your 1031 exchange with an intermediary who uses segregated accounts for each customer. Also make sure that the full value of your account is protected at the bank you use. FDIC insurance is generally limited to $250,000 per account holder. Last but not least, some 1031 customers may not realize when an accommodator company they’re using isn’t in compliance with tax rules. Remember: 1031 exchange companies don’t generally provide tax advice unless they employ tax experts on staff.