Guaranteed Returns, Commingled Funds & Related Company Transactions

In 2002, an Internal Revenue Service ruling (Procedure 2002-22) set forth guidelines for purposes of determining where undivided fractional ownership interests in real estate could be treated as ownership of real estate. Under the ruling, if "essential elements" of the TIC arrangement are followed, TICs qualify for 1031 exchange deferral of taxes. The structure of a TIC can be beneficial to many investors tired of active daily real estate management. There are many solid TIC sponsors in the market today. However, this is the story of one that wasn't.

By 2005, TICs were a hot commodity. At one time, Boise, ID-based DBSI, which operated under names such as Spectrus Real Estate and For 1031 LLC, was riding near the top of the heap. The 29 year old company became one of the nation's biggest sponsors of Tenant In Common (TIC) ownership interests in commercial properties across the United States. By providing smaller investors with access to the institutional properties markets and, in some cases, a guarantee of investment returns (from 6.5% to 12% returns annually -- whether or not the property performed well), DBSI became one of the most well-known TIC sponsors in a rapidly growing industry. Guaranteed returns, regardless of performance....really?

But as the commercial market began slowing in 2007 and 2008, DBSI began reporting problems. By September 2008, the house of cards quickly began to crumble. In a letter to investors, DBSI indicated it was "temporarily" reducing or eliminating payments. Within six weeks, DBSI had declared Chapter 11 bankruptcy. With the bankruptcy, day-to-day management of its properties broke down.

In October 2008, bankruptcy court-appointed examiner Joshua R. Hochberg, former chief of the Justice Department's fraud section, began investigating claims of fraud. He was directed to investigate allegations that DBSI defrauded investors out of $500 million. DBSI founder and president Douglas Swenson was alleged to have taken somewhere in the neighborhood of $160 million ( (Swenson's counsel denies he did anything wrong).

Hochberg’s (preliminary report, released in June, indicates a tangled web of closely related companies primarily controlled by Swenson. Transactions within the company - including transfers among DBSI related companies, Swenson, and four other minority owners - were more numerous that previously believed. Instead of investing the money as promised, Hochberg declared that the company was "an elaborate shell game." Hotchberg's report seems to indicate that as the market cratered, and new cash infusions dramatically slowed, DBSI and its affiliates used new investor proceeds to continue their daily operations and pay off existing debts. His report also claims that Swenson, DBSI and several other executives exerted control over dozens of DBSI affiliates and essentially ran them as a unified business with commingled funds (where have we also heard this other major problem before?).

Hotchberg continues to investigate the demise of DBSI. A more complete, final report should be out soon. What will the report conclude? Based on the the initial report indicating commingled funds, closely-related transactions and guarantees of returns - three major flags in previous schemes - I'd say it, unfortunately doesn't look good for investors.

LandAmerica and Okun

The Federation of Exchange Accommodators released their November newsletter recently updating member firms about the legal proceedings in the Ed Okun and LandAmerica Exchange cases.

The Okun case sentencings have now been completed for the wrongs committed in the failure of 1031 Tax Group. The last of three former employees, the chief legal officer of Okun's organization, was sentenced to three years in prison. Along with the 100 year prison term Okun was sentenced to earlier, the chief operating officer was sentenced to 10 years and to five years.

In the LandAmerica case, it appears there is a possible settlement pending on the bankruptcy proceedings. Customers who set money with LandAmerica but did not specify exactly how it was to be held will get $0.25 on the dollar from the former Qualified Intermediary arm of LandAm Title. Customers who put funds in segregated accounts will get will get $0.70 on each dollar they set aside, and customers who specified their funds be put in escrow will get $0.97 on each dollar they put with LandAmerica. In this case the court took a very stringent view of tracing and heavily weighed the argument that the funds were not co-mingled. Seggregated accounts is something we've always strongly advocated (and always followed in our practice).

With the approaching holiday, we at 1031 Corporation want to wish you all a Happy Thanksgiving. We know this year hasn't been an easy one for many of us but we certainly realize there is still much for which to be thankful. We hope your travels will be safe and that you'll enjoy time invested (I always hated the idea that we SPEND time) with family and friends.

Arizona 1031 Fraud Conviction

Late Friday, a Phoenix television station reported news that a Litchfield Park married couple that had claimed to be a Qualified Intermediary was convicted of fraud. The couple did business under the name 1031 Exchange Consultants, LLC (as well as Etna Land Trust; Executive Realty Group; and Tax Management Consultants, LLC).

Owner of 1031 Exchange Consultants, Gordon Deibler, acted as a Qualified Intermediary (QI) through the companies and accepted the proceeds from property sales for clients. Instead of securely holding the funds and then using the proceeds to purchase replacement property for his clients, he diverted the money for personal use.

The couple was also involved in a mortgage loan scheme with their handyman where they inflated the property value and falsified credit and income information for a loan application.

According to news reports, Mr. Deibler pleaded guilty to one count of directing a criminal syndicate and one count of fraudulent schemes and artifices. He faces a prison term of somewhere between three and twelve years and was ordered to pay restitution to the victims in the amount of $1.6 million.

Once again we have a story hitting the news of another fraudulent individual acting as a Qualified Intermediary. While regulation may slow some of these schemers down, criminals will still find ways to break any laws written. This couple is a perfect example of that. I don't think it would have mattered what laws were written. They clearly had no conscience about stealing money from individuals that placed their trust in them.

We've written of the need to fully investigate the Qualified Intermediary you use. Much like you would want to know the bank you place your money, the investment advisor you use, the accountant or attorney you retain, you should review the qualifications, experience and safety of your Qualified Intermediary. 1031 Corporation is a subsidiary of FirstBank. While a bank-owned QI is not the only choice, investment requirements of banks are highly regulated. Further, a typical bank-owned Qualified Intermediary will segregate funds, have a high amount of bonding and financial backing as well as have dual control procedures in place to ensure checks and balances are maintained.

You have a choice when selecting a Qualified Intermediary. You should use that choice to make sure you are comfortable knowing who is assisting you in your 1031 exchange needs. Give us a call at 888-367-1031 if we can assist you with questions or setting up your 1031 exchange today.

1031 Corporation Parent Reports Strong 3rd Quarter

As reported yesterday in the Northern Colorado Business Report, - FirstBank Holding Company - the Lakewood-based holding company for the largest locally-owned banking organization in Colorado - reported increases in all its key financial measures for the nine months ending Sept. 30, 2009. Net income grew was up 15 percent to $109.88 million compared to the same period in 2008. The company's earnings increased by 17 percent from the comparable period a year ago.

Total assets were $9.84 billion and total deposits increased to $8.95 billion, up 6 percent and 13 percent respectively. Total loans grew 9 percent to $4.22 billion, and return on average shareholder equity was 22.1%.

"FirstBank has performed exceptionally well in 2009, and our third-quarter financial results show that we've been able to sustain the momentum we created during the first half of 2009," said John A. Ikard, president and CEO of FirstBank Holding Co. "Concentrating on our core business has allowed us to better serve our customers and deliver value to our shareholders."

Ikard noted that FirstBank does not originate, hold or purchase any subprime mortgage loans or securities, a fact that has helped the company avoid costly credit losses.

FirstBank also expanded its geographic footprint during the third quarter of 2009 by opening a new branch location in Surprise, Ariz. It operates 121 locations in Colorado, eight in Arizona and five in California, serving more than 600,000 customers.

1031 Corporation, a subsidiary of FirstBank offers nationwide Qualified Intermediary services and strategy consultation for tax-deferred, like-kind exchanges.

All-Cash TIC Advantage for 1031 investments

Some time back, I saw an interesting article by Robert Johnson - president of St. Paul-based AEI Capital Corporation - discussing the advantages of an all-cash tenant-in-common investment. I asked, and received, his permission to re-publish some of the important issues he describes in the article. The full article appeared in the January 2009 National Real Estate Investor. The article contains solid information for 1031 investors that lack debt in their relinquished property and are looking for suitable replacement property investments.

Access to affordable capital has rapidly become a difference maker in the tenant-in-common industry. TIC sponsors that able to use an all-cash acquisition and offering strategy are getting a leg up on their leverage-dependent competition. Moreover, a lack of acceptable financing is forcing some leveraged TIC sponsors to delay bringing. or to pull altogther, deals to the market.

Sales volume in the Tenant-In-Common industry has been reduced due to a decline in U.S. real estate sales and the corresponding decrease in demand for 1031 exchange properties which enable investors to defer capital gains taxes. Despite the drop in sales volume, the TIC property ownership structure remains sound for suitable 1031 exchange buyers.

Benefits of an all-cash TIC transaction include no foreclosure risk, no interest rate refinance risk, and less risk of capital calls. Added benefits include avoiding the bank application process, easier resale, and flexible 1031 exchange closing schedules.

All-cash TIC properties usually generate a slightly lower rate of return. On the other hand, the front-end fees associated with all-cash transactions will normally be less than those of TICs using debt. Ultimately, the all-cash model provides an added layer of protection that is attractive in a market where investors are increasingly averse to risk.

Although TIC offerings requiring leverage are still offered, they are considerably more difficult to organize in today's relatively illiquid market. As financing has become more expensive, and difficult to obtain, the advantages of an all-cash strategy become more meaningful for 1031 investors.

As Mr. Johnson points out, all-cash TIC offerings tend to focus on properties priced under $10 million and may not be suitable for all 1031 exchange investors looking to reduce risk (larger, institutional-grade properties are typically perceived by investment professionals to contain less overall risk). TIC offerings should be reviewed with full due diligence and a complete understanding of the investment risks. If you are considering an investment in a tenant-in-common property, you should discuss the offering details with your legal and tax professionals. For futher details on the ideas expressed here, contact Robert Johnson at 800-328-3519 or at aei1031@aeifunds.com.

Reality of Lending

Our economy is struggling. We all know that. But understanding why, what happened, and how the banking industry and the government is responding can be complicated and timely. The Colorado Bankers Association recently released information about the "lack of lending” in order to encourage the appropriate coverage of the issues surrounding this frustrating topic.

They have released a brochure titled, The Reality of Lending that details what they believe to be reasons for the current "credit crunch". Below is some of the highlights of the facts they are hoping are addressed.

Banking takes appropriate responsibility for its prudent loan standards. We also think customers and the public deserve to understand other factors that significantly impact the ability to get credit in this environment.

The lack of lending (heavily criticized by the public, media, and public officials) reflects low loan demand and is attributable to borrower creditworthiness issues, lender financial constraints, and regulators’ tougher standards, and is exacerbated by the greatly diminished role of nonbank lenders recently. For business borrowers who are key to an economic recovery and already have financial strain this means banks are their primary source of credit and banks are unable to make many of the loans for the reasons stated. This is especially difficult for loans secured by real estate.

Changing regulatory standards in capital requirements, loan concentrations, and loan downgrades often result from subjective judgments and national benchmarks. They disallow recovery of real estate values over time, and often prompt shrinkage of the bank which reduces lending and greatly impacts customers.

Bank lending plays a critical role in our economic recovery. Borrowers and lenders are addressing financial constraints and are working through issues. Bank regulation and examination are essential to a sound banking system. CBA recognizes this essential role but also believes regulators are impairing bank lending and thus the recovery by overly aggressive actions in capital standards, concentration standards, and loan downgrades. CBA is providing essential information to bankers, public officials, the public, and major customer groups.

The site titled Financial Information for Consumers has additional information on this and other topics such as Home Mortgages, Identity Theft, Credit Awareness and Loans.

Related party basis shifting case upheld

A Ninth Circuit Court of Appeals decision to affirm a previous Tax Court ruling further highlights the need for extra scrutiny in 1031 exchanges involving related parties. The 2005 Tax Court decision, involving exchanges of condominium and apartment properties (Teruya Brothers), disallowed the tax deferred swap because it occurred between related parties and the main reason for the exchanges was to reduce the overall tax bills of the buyer and seller.

In the case, the entity (Teruya Bros, Ltd) that owned the apartment building and condominium complex had a built in, large capital gain. Upon the sale, a $13 million capital gain would have resulted to this entity triggering a massive tax bill. Rather than sell, the entity transferred the real estate to an unrelated Qualified Intermediary (QI) which sold the properties and bought replacement land from a subsidiary (Times) in which the entity had a controlling interest.

The issue that causes this related party exchange to be disallowed essentially relates to the overall tax paid. The subsidiary did not exchange into additional replacement property. Rather, it chose to treat the sales as taxable events and accounted for a capital gain of roughly $3.5 M on the property sale to the related entity. However, the subsidiary that sold the property had significant net operating losses from previous operations. These NOLs were used to offset the $3.5 million gain - resulting in no taxes paid on the sales.

Effectively, what the related party exchange attempted was a "cash out". The subsidiary now had the cash from the sales. The two related entities combined had decreased their investment in real property by approximately $13.4 million while increasing their cash position by the same amount. By disallowing the related parties to cash out of a significant investment in real property under the appearance of a 1031 like kind exchange, the Appeals Court upheld the previous Tax Court decision that "these transactions were undoubtedly structured in contravention...that nonrecognition treatment only apply to transactions "where a taxpayer can be viewed as merely continuing his investment.""

It is clear that tax deferred exchanges between related parties are subject to additional scrutiny. Accounting professionals, tax and real estate attorneys and taxpayers should be familiar with, and aware of the potential pitfalls, in exchanging property between related parties. The use of a Qualified Intermediary familiar with the rules and legal precedence in dealing with this advanced topic can be of assistance in handling a related party exchange appropriately.