States Begin Regulating 1031 Exchanges

In September, California signed a law that became effective on January 1, 2009 regarding companies facilitating 1031 exchanges. The new law holds Qualified Intermediaries (QI) to new requirements on property exchanges taking place in that state. California wasn't the first - Nevada and Idaho had previously approved legislation on the Qualified Intermediary industry. But, California passed legislation that has the intent to protect consumers while minimizing costly and burdensome regulation to 1031 exchange companies that was sure to be passed on to consumers.

The California 1031 law has become a model of consumer protection for other states, such as Colorado, Arizona and Washington, now considering similar legislation. Some of the requirements include requiring 1031 exchange facilitators to maintain bonding and insurance. They require Qualified Intermediary companies to notify clients of any change in the company's control (as in a sale or other controlling change in management). The California law also requires exchange companies to invest exchange client funds in a way that meets “prudent investor standards”. This last point is, perhaps, the most important measure included. No longer will exchange companies be able to loan funds to affiliates or owners to fund other "investments" (bank-owned Qualified Intermediaries are exempt when depositing funds in bank accounts with a parent bank).

This follows on the heels of a recent industry failures that have affected a significant number of 1031 exchange clients. A couple of high profile cases involve 1031 Tax Group and Southwest 1031 Exchange. LandAmerica Financial Corporation's recent bankruptcy filing (due to LandAmerica Exchange's lack of liquid investments) reiterated the point that additional guidance and regulation was necessary. Exchange intermediaries that are found to have not held the funds in a prudent manner - or otherwise fail to meet the "model law" requirements - could be subject to civil and criminal penalties. It also gives some recourse to injured exchange clients to file a claim against the required bonding, cash deposits, or letters of credit.

States that follow are using the California "model law" as a template for sound, practical legislation that doesn't create undue burden on exchange companies while, at the same time, providing protection to consumers. Each state, most likely, will have their own changes to the model. But the California 1031 law is a welcome trend for ethical, prudent exchange companies and the clients that employ them to facilitate their 1031 exchange tax strategy.