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UPDATED: A 1031 Cautionary Tale: Where Did the $130 Million Go?

Buyers in More Than 300 Pending Deals Left in Lurch as 1031 Intermediary Goes Belly Up
May 23, 2007
Where to start with this story? It has so many moving parts and players: more than $130 million in missing money for starters, and criminal investigations, civil lawsuits and hundreds of real estate deals hanging in the works. Then likely to follow from it all could come additional scrutiny on the burgeoning 1031 tax exchange industry.

The troubles came to light last week when The 1031 Tax Group LLC, a Richmond, VA-based privately held consolidated group of qualified intermediaries for deferred like-kind property exchanges, filed for chapter 11 reorganization in U.S. Bankruptcy Court for the Southern District of New York. Edward H. Okun is owner and sole "member" of The 1031 Tax Group.

Also filing for chapter 11 were 16 other firms rolled up as subsidiaries of The 1031 Tax Group, each designated as qualified intermediaries created to service real property exchanges. The intermediaries are spread out across the country including in San Jose, Boston, Denver, San Antonio, Tampa and New York.

(Editor's Note: This story was last updated: Thursday, May 24, 7:10 pm. The 1031 industry has seemingly done a commendable job in self-regulation, but given the enormous amounts of money entrusted to 1031 intermediaries, is the industry ripe for abuse and in need of more state or federal regulation? Let us know what you think, e-mail me at mheschmeyer@CoStar.com. Read excerpts from pertinent follow up comments at the end of the story as they are added.)

For the record, the others are: 1031 Advance 132 LLC; 1031 Advance Inc.; 1031 TG Oak Harbor LLC; Atlantic Exchange Company Inc.; Atlantic Exchange Company LLC; Exchange Management LLC; Investment Exchange Group LLC; National Exchange Accommodators LLC; National Exchange Services QI Ltd.; National Intermediary, Ltd.; NRC 1031 LLC; Real Estate Exchange Services Inc.; Rutherford Investment LLC; Security 1031 Services LLC; and Shamrock Holdings Group LLC.

(Editor's Note: It is important to note that Real Estate Exchange Services, Inc. (REES), a Georgia corporation based in Marietta, is not affiliated or associated with the Florida corporation also named Real Estate Exchange Services, Inc., or its parent company, The 1031 Tax Group, or any related subsidiaries that filed for bankruptcy protection. Real Estate Exchange Services, Inc. in Marietta is not connected to The 1031 Tax Group.)

1031 Tax Group et.al. cited "liquidity issues" in its decision to file for bankruptcy protection, including the actions taken by several financial institutions in blocking access to 1031 Tax Group's funds. The debtors estimate that on a balance sheet basis their assets exceed their obligations to customers and others.

Calling them liquidity issues is putting it mildly. The 20 largest creditors listed with the initial bankruptcy filing were listed as being owed more than $65 million.

In a typical 1031 exchange, an exchanger sells its business or investment real estate and then has 45 days from the date of sale of the property to identify a like kind replacement property and it has 180 days from the date of the sale to close on the purchase of that replacement property without suffering any tax consequence.

In order to preserve the tax deferral, the exchanger cannot take title to the proceeds of the first sale, but must instead deposit the proceeds with a "qualified intermediary," until such time that the exchanger is ready to close on the replacement property.

In The 1031 Tax Group's case there were more than 300 open exchange contracts representing an estimated liability of $151 million outstanding at the time of the bankruptcy filing. Deals ranged in size from tens of thousands of dollars to $10.5 million.

That means there are more than 300 individuals or business entities now bumping up against a 180-day Internal Revenue Service-imposed window to conclude the second half of their real estate exchange, or face tax burdens and penalties. According to court papers, lawyers have begun petitioning the IRS seeking relief and to avoid paying taxes on money that has disappeared.

And according to The 1031 Tax Group's filings, it does not have that money to meet those property closing obligations. Where the money is, remains a mystery.

According to Okun, owner of The 1031 Tax Group, in statement made in bankruptcy court filings, at least some of the money is tied up in frozen bank accounts. The largest amount is between $10.5 million and $19.3 million in an account at the Colorado Capital Bank in Denver. The bank has frozen those assets.

Okun maintains the funds were deposited without his knowledge and against the 1031 Tax Group's approved practices. The 16 members of the group were supposed to deposit exchange money into a single, central account.

However, according to bankruptcy court filings, the central account had only $76,000 in it and outstanding checks of more than $30,000.

According to bankruptcy court records, a preliminary investigation by the U.S. Attorney's Office in Richmond, VA, has begun concerning the activities of the group. The U.S. Postal Inspector issued a federal search warrant in April prior to the bankruptcy filing for documents in connection with the federal investigation.

Okun's lawyers say he is cooperating fully with the federal investigation and is complying fully with all requests.

The date of the federal search warrant is important because the 1031 Tax Group isn't Okun's only troubles.

On May 9, Okun and his affiliated companies reached an agreement to settle three separate lawsuits arising out of the termination of a merger agreement in which Okun agreed to purchase First Montauk Financial Corp. in Red Bank, NJ.

Under the settlement, Okun agreed to invest $2 million in First Montauk through the purchase of preferred stock or convertible debt directly from First Montauk within 90 days after approval of the settlement by the federal district court, where three lawsuits are pending.

The parties originally executed a merger agreement on May 5, 2006, under which affiliates of Okun would purchase all of the outstanding shares of First Montauk for $1 per share in cash.

However, in December First Montauk reported that the merger agreement had been terminated by the Okun affiliates and three separate lawsuits by the parties followed.

In February 2007, Okun, through affiliates, purchased additional shares of common and preferred stock of First Montauk, which gave him voting control of the company.

Now, First Montauk officials have moved in New Jersey State Court to vacate the settlement agreement.

The Montauk board of directors authorized the action after learning of the federal criminal investigation through the 1031 Tax Group's bankruptcy filings. According to First Montauk, the filings reveal that Okun affiliates transferred more than $100 million of customer funds entrusted to The 1031 Tax Group to another Okun affiliate. That money was originally deposited by customers and was to be held on a short-term basis pending reinvestment of the funds. Okun and his affiliates 'borrowed" the funds, leaving The 1031 Tax Group without the capital necessary to satisfy customer withdrawal requests.

Critics say the size and extent of the Okun case highlights the need for greater oversight to protect investors from what they see as a major flaw in the like-kind exchange system - a lack of federal oversight on this legal way to shield capital gains from the IRS, according to a report by the Florida Association of Realtors.

Pat McCaffrey, a representative of another national 1031 exchange company, Investment Property Exchange Services Inc., told the Florida Association of Realtors that the bankruptcy is "a black eye for the industry."

"It's a non-regulated industry," McCaffrey was quoted as saying. "Anybody can hang up a shingle in their garage, and people will give them millions of dollars."

McCaffrey says he would "welcome regulation," but in the meantime recommends that investors don't just ask a company if it's bonded, but also "read the bond and see what the bond will pay for."

Currently, only one state, Nevada, regulates 1031 exchange intermediaries - but only minimally.

"(1031 exchanges) are a niche industry," Chris Lee, deputy secretary of state of Nevada told the Florida Realtors group. "They've flown under the radar for a very, very long time. For the amount of money they handle, it's amazing that no one is regulating them."

(Is the 1031 industry ripe for abuse and in need of more state or federal regulation? Let us know what you think, e-mail me at mheschmeyer@CoStar.com. Read excerpts from pertinent follow up comments at the end of the story as they are added.)

Follow Up Comments from Readers

It is time to regulate the industry, it is mind boggling that the banks who hold the money for these accommodators cannot be held liable to some degree if any wrong-doing is suspected. The exchange company should not be able to "borrow" the money that belongs to their clients for any purpose. As a Realtor with ethics, I work very hard to do the right thing for my clients, and I would like to think that I can entrust their money to a company that will not stiff them.

Carolyn Bustamante
Realtor
San Antonio, TX

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I see no need for regulation. Where were the lawyers here? They should know and take responsibility for only utilizing QIs (Qualified Intermediaries) who are trustworthy. I see no reason for QIs to ever claim any share of "investment income" and would not allow a client to use one who requested such. Anyone who places a great deal of money with a QI should be utilizing a lawyer to complete the exchange and it appears to me that the people losing in this deal are largely big deal people and not small deal people who might be seeking QI treatment as a gimmick rather than as a real tax deferral strategy. QI choice risk is a real factor in utilizing 1031 and taxpayers are not entitled to use it without the risk associated with it. (In other words, regulation will make it more expensive and difficult than the IRS rules already make it and that is not a good thing).

J Paul Raymond
Esquire
Clearwater, FL

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Are you kidding? This was inevitable with the explosion in activity behind the TIC ruling.

Jay Boslin
Designated Broker
Biltmore Real Estate Co., LLC
Phoenix, AZ

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IRC Section 1031 exchanges should definitely have some simple regulation. First and foremost, there should be some sort of licensing requirement to handle 1031 exchanges. Anyone holding a valid license to practice law, accountancy, banking, title insurance, Surety bonding or securities trading should need only register as intermediaries. Others desiring licensing should obtain a license through a prescribed procedure of education, testing and bonding. Once licensed, regulation would be a simple matter of instituting a board of supervisors to conduct oversight on the industry. The hallmark of the oversight would be that all intermediaries must maintain escrow accounts for exchange funds and report all activity to the controlling board. Each intermediary would be required to report each transaction commenced and completed and submit detailed accounting monthly of all funds held, broken down by client and individual transaction. The controlling board should be given powers to grant, suspend, revoke or take other action against licenses and to impose fines. The board would be funded by license fees and possibly transaction fees.
The simple fact is that we regulate lawyers, accountants, real estate professionals, insurance professionals, medical professionals and all manner of other professions that have fiduciary responsibilities. It is only logical that intermediaries be regulated and monitored.

Thomas C. Legg, JD

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Unfortunately the unregulated qualified intermediary is just one of many risks involved with the 1031 tax exchange industry. Not only are the qualified intermediaries not regulated but the IRS and SEC [Securities & Exchange Commission] are ignoring the TIC [Tenant-in-Common] industry. A quick look at any TIC offering and you’ll quickly see the deals are financial Ponzie scams. From exorbitant fees (30%+), over the top pro forma speculation and transaction structures that will not hold up to IRS scrutiny.

It’s no coincidence that qualified intermediaries and TIC Sponsors are so closely entangled, both taking advantage of unsuspecting 1031 investors.

Eric Westcot
Colorado Springs, CO

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Should the 1031 industry have more regulation?

It scares me that many of your respondents want more attorneys and more regulation. Is an attorney any better judge of character than I am? Do I have to then hire an attorney to deal with a bureaucracy who is overseen by another bureaucracy and a portion of my equity is has to pay for all this nonsense. If the industry does not have direct control on our funds and the process is simplified, then all this regulation and all these attorneys are unnecessary.

There does need to be just a little more regulation but not much. In short, separate accounts should be required for all exchanges with one of the required signatures on that account being that of the exchanging party. That will end the abuse or the possibility of abuse without a lot of government oversight. Commingling of funds in any way, shape or form should be illegal!

Now lets take this a step farther. Why not get rid of the entire industry. It serves no useful purpose. It only adds a layer of bureaucracy to the real estate industry and the economy and does not add any productive element to either. Why not simply allow investors to reinvest THEIR money within a certain period of time. If they don't, they pay their taxes. If they do, they get their deferral.

Is this way to simple or am I missing something?

Cleve Schenck
Performance Brokers
Denver, CO

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