Money Management - February 2008

1031 Exchanges In Nevada

Is It Safe To Go Back In The Water?

by Don Martin

On the heels of the Southwest Exchange Corporation litigation, the Nevada Legislature has moved quickly to reduce the risks associated with 1031 exchange accommodators. Exchanges are highly regulated for qualification as a tax deferred exchange under the Internal Revenue Code, however, state regulation of exchanges has been limited or non-existent. Prior to the new regulations, Nevada’s exchange regulations were minimal. With the newly enacted regulations, is it safe for real estate investors to play in the 1031 waters again, or do they remain at risk of losing exchange funds?    

A “1031 exchange” is a tax-deferred (not tax-free) exchange under Section 1031 of the Internal Revenue Code. Section 1031 permits a taxpayer to defer gain on the sale or exchange of certain types of property. For delayed exchanges, a qualified intermediary must hold the funds received from the sale or exchange until the replacement property is purchased. It is the regulation of these intermediaries that leads to the risk of the taxpayer losing its exchange money.

The new regulations bring qualified intermediaries under the control of the Division of Financial Institutions (DFI) of the Nevada Department of Business and Industry. The DFI now has regulatory and auditing rights and controls over an intermediary, which will permit stricter oversight of the exchange industry in Nevada. The DFI also has broader authority to suspend or revoke an intermediary’s license and may impose fines for non-compliance or failure to obtain a license. However, these fines may not be sufficient at $200 per day, per violation.

The key to the legislation is the protection of the funds held by the intermediary. First, the intermediary, as a fiduciary of the client, must deposit all exchange funds in a financial institution that is federally insured by a private insurer. The funds must be clearly designated as “trust funds” or “escrow accounts” and must be kept separate and apart from the intermediary’s funds. Second, the funds held for the account of a client may not be withdrawn from the holding account without the signature of the taxpayer. This offers significant protection to clients that was non-existent prior to this legislation. Third, the security to be posted by the intermediary has been raised to $1 million. However, given the larger dollar values typically involved with exchanges, this limit should be raised higher, or tied to the value of specific transactions. Finally, intermediaries are required to maintain $250,000 of errors and omissions insurance.

A 1031 exchange can deliver many potential benefits, including tax deferral, diversification of investments, exchanging one large parcel for several smaller parcels, or vice-versa, and participating in fractional interests or tenants-in-common arrangements (allowing for participation in a higher value transaction that otherwise would not be available to a small investor). The benefits of an exchange can outweigh the risks associated with entrusting funds to a third party. To further reduce risks, a taxpayer should ask the intermediary how the funds are protected, make certain the funds are placed in a separate account with a reputable financial institution, and verify the existence of bonding or other posted security. Although not a guarantee, using large title companies, banks or their affiliates may reduce the risk of foul play and wrongdoing.

In short, conduct due diligence to protect your investment. While the new Nevada regulations do not guarantee protection of a 1031 participant’s funds, the legislation provides significantly more protection than was previously available. So although the 1031 exchange waters are not 100 percent safe from thieves and schemers, the risks associated with intermediaries have been substantially reduced.

Don Martin
Don Martin is a partner with the law firm of Fennemore Craig, a regional firm with offices in Nevada, Arizona and Colorado