State Regulation of 1031 exchanges

Because of a couple high dollar, high profile cases involving Exchange Facilitators that have failed in the past year, many states are considering regulation of the 1031 industry. While some pending legislation makes a good deal of sense, over-zealous regulation proposals provide little real substance while substantially increasing costs to Qualified Intermediaries (which, of course, will be passed on to consumers) and making it more difficult for Exchange Facilitators to do business.

Nevada was first in the nation to regulate the Exchange Facilitator industry. It is somewhat ironic, then, that the first high profile case involved a company in Henderson, Nev. called Southwest Exchange. In response, Nevada legislators worked to revise its existing regulation by placing greater oversight in the licensing approval process. Unfortunately, the costs of the increased regulation were not thoroughly considered and state regulatory administration resources were not in place when the law was enacted. Nevada is now discussing revisions to its regulation to reduce the increased costs of oversight.

Idaho, through its Escrow Act, also has claim on being one of the first states in the country to regulate Qualified Intermediaries. Its regulation aims to "keep things local" by requiring funds be banked in an Idaho bank. It also requires some measures aimed to protect the consumer from fraud.

While both Nevada and Idaho, and other states considering legislation, should be commended for attempting to protect consumers, the regulations put in place don't really address the heart of the issues involving the examples of the failures at Southwest Exchange and 1031 Tax Group. What these two companies have in common is that a change in ownership occured just prior to their troubles. The new owners of both companies decided on a change in "investment strategy" that involved temporarily lending funds being held for exchange clients to related-party, closely-held investment entities. Unfortunately, when it came time to repay these loans, these related, closely-held investment entities were unable to repay the debt causing the Exchange Facilitator companies to default on their client obligations.

While experienced staff, bonding requirements and segregation of accounts is something many honest Qualified Intermediaries already possess, regulation calling for these requirements misses the point. The real problems arose due to the change in ownership and the ability to move and invest funds without fiduciary requirements. Regulation, outside the issue of ownership changes and prudent investment and banking, goes beyond what is needed - at increased cost to consumers - and does little to actually protect exchange clients.

One state with pending legislation has it right.

Legislators in the State of California (yes, believe it or not, I said California - one of the most heavily regulated and consumer protection-friendly states in the country) has initiated regulation that makes sense, provides substantial protection to 1031 exchange participants and allows Exchange Facilitators to do business without substantial increases in cost structure. The pending bill looks at the heart of the matter in the two high profile cases - change of ownership and movement of exchange funds. It requires Exchange Facilitators to notify exchange clients, and the State, of ownership changes. It also requires them to receive the clients' written approval before any movement of funds. It advocates education and responsibility rather than enforcement and restriction.

Had both these requirements been in place, would fraud have occured at Southwest Exchange and 1031 Tax Group? Probably. Bad people are going to do bad things. However, it would have made it more difficult and given law enforcement the necessary tools to penalize them. It would have provided a sensible legal response to regulation of the 1031 industry. All without putting onerous and costly regulatory burden on Exchange Facilitators by adding requirements that don't really do much, in the end, to protect the consumer.