The hidden face of 1,031 real estate exchanges
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The bankruptcy and multiple lawsuits related to the alleged involvement of Franconia-based Edmund & Wheeler Inc. in a nationwide Ponzi scheme raise a number of questions about the regulation of the real estate reinvestment tool known as the ‘exchange 1031.
A similar exchange 1031, so named after Section 1031 of the Internal Revenue Code, allows individuals and entities that sell commercial property to delay payment of capital gains tax by purchasing or by investing in another similar asset of equal or greater value.
The 1031 exchange isn’t a new tool – in fact, it’s been around for exactly 100 years. But the future of these exchanges may be uncertain, as the Biden administration seeks to severely limit their use.
They are very common. Although the data is difficult to obtain, an estimate in a study published by the Real Estate Research Consortium indicates that exchanges of the same nature are involved in 10 to 20% of commercial real estate transactions, resulting in a loss of revenue of nearly 10 billion. dollars for the government.
Fraud is rare, but it happens regularly. And that usually involves a qualified intermediary – known as an IQ – which the IRS requires but doesn’t really regulate.
Most investors, especially those new to the 1031 exchanges, view IQs as a neutral party, holding their money in escrow. The law prevents them from keeping it for too long, as sellers have to meet strict deadlines to qualify for the tax break. They have 45 days from the closing of the sale to select a new property to reinvest in and 180 days from the closing to purchase that property.
The tight deadline can put pressure on sales, especially when the IQ could be in a conflict of interest.
The Florida Board of Realtors cited a 2007 Ponzi scheme involving IQs in Nevada and California in which $ 95 million of customer revenue was used to fund investments, including a breast implant manufacturing company. .
In 2009, the CEO of an QI company in Virginia pleaded guilty to embezzling $ 132 million in client funds to invest in his various businesses and lavish lifestyle.
In 2012, the Federal Trade Commission said it was aware of 23 cases where investors lost a total of $ 250 million as a result of IQ fraud.
In 2018, the SEC filed emergency action against a California IQ who used $ 24 million in a Ponzi scheme to reimburse previous investors and take over $ 2 million for itself.
As reported in the September 10-23 issue of NH Business Review (“NH Investors Entangled in Real Estate ‘Ponzi Scheme”), no one is accusing John Hamrick, the head of based Edmund & Wheeler. Franconia, for having simply fled with funds from investors.
These Ponzi scheme allegations are aimed more at Noah Corporation and Rockwell Debt Free Properties for mixing investor money that was intended for a slice of a particular property and using it to pay investor rents in previous properties, until the whole business goes bankrupt. .
Instead, the lawsuits against Hamrick accuse him of dragging people into this business, even though he knew or should have known they were on shaky ground because they were receiving hefty commissions from Rockwell who were not disclosed to customers.
Instead, the clients allege they were told that all Edmund & Wheeler would receive was a small $ 750 from the investor.
New Hampshire investor Stephen LaRosa said he didn’t understand how Hamrick could make a living with so little compensation.
âThat’s all we get. I love doing my job, âLaRosa said, Rockwell told him. “And we found out he was getting bribes from Rockwell.”
Multiple lawsuits claim he was getting a 5% commission that he did not disclose to Rockwell investors. The money actually went to Mary O’Toole, a partner of Edmund & Wheeler who is also Hamrick’s “life partner”, according to documents filed on both sides of the lawsuit.
“Hamrick has entered into an agreement with O’Toole Enterprises whereby commissions owed to E&W and Hamrick … which might otherwise be available to plaintiffs,” according to a complaint in the Denver second lawsuit.
Hamrick doesn’t call them bribes or commissions, but âreferral feesâ and said they were disclosed âevery time in the contractâ. When asked to show one of those contracts, Hamrick refused. (O’Toole did not return a phone call left at his office.)
However, in another lawsuit, filed in Vermont, E&W revealed in an advisory agreement that it “may derive referral fees from certain providers of alternative real estate and will disclose those potential fees,” but the contract does not say. not what those charges were.
In a response, E&W attorneys said that with respect to the discovery, “the defendants will provide evidence that the removal costs have been disclosed.” However, even if they were not, the company “has not plausibly alleged a causal violation of their damages,” the attorneys said.
But all of the complainants NH Business Review spoke to said the fees were withheld, and several said it should be illegal for qualified intermediaries to charge referral fees, especially those who are not disclosed.
There are no federal regulations governing fees, but 13 states have laws imposing qualified intermediary license requirements, management skills and standards for holding exchange funds, according to Lynn. Harkin, Executive Director of the Federation of Exchange Accommodators. But, when asked which states they were, Harkin declined to answer.
Harkin said the FEA has a code of ethics that doesn’t prohibit referral fees but requires disclosure. When asked if a law required disclosure, she again declined to answer.
FEA’s lack of interest in talking about QA regulations can be understandable as right now they and other business groups are fighting for the very life of the practice.
To help pay for his $ 3.5 trillion spending plan, President Biden is including a provision that would only allow a deferral of $ 500,000 in capital gains tax ($ 1 million for married couples). ). The proposal has created a storm of opposition from the real estate industry, which claims the change would result in the loss of hundreds of thousands of jobs linked to the deals.
Mackay, Caswell & Callahan, a New York tax and commercial law firm, lists eight states that regulated foreign exchange facilities in 2019, including New Hampshire, although it turns out New Hampshire law – Senate Bill 483, passed in 2010 – was designed to ensure that these exchanges do not go against the unique granite state tax structure and have nothing to do with IQ. Nevada appears to be the only state that allows IQs, requiring them to post a bond, but they don’t regulate fees and disclosure.
The New Hampshire Real Estate Commission does not regulate 1031 exchanges.
And the question arises as to whether the Securities Division can do something about them as well. The industry – and E&W is no exception – insists that investors who are âcommon tenantsâ are simply buying real estate so that commercial real estate buys the same amount that was sold.
But in cases like Noah / Rockwell, when the funds are mixed and don’t actually go to a particular property, the SEC maintains that it is securities. Hamrick claims not, and this is one of the things the State Securities Division must determine during its investigation, because in order to sell securities you must be authorized to do so.
This loophole in the law is reminiscent of the financial resources mortgage scandal that erupted in 2009, the biggest Ponzi scheme in New Hampshire history. While this does not involve 1031 exchanges, it did involve investors thinking they were buying real estate when they were actually just pouring money into a company that mixed funds and was ultimately forced into bankruptcy.
Although the perpetrators went to jail, it was unclear exactly who was regulating the activity, and there was a lot of fingerprinting among the agencies involved:
Securities, bank and attorney general’s office. The state legislature has felt responsible for the fiasco, as it set aside $ 10 million in this year’s budget to compensate victims.
Representative Judith Spang, D-Durham, remembers the scandal, although she ended up opposing the funding, arguing that investors should swallow their losses and the money should go to human needs.
âI don’t think the governor should be paying for private investments that have gone wrong,â she said. “Back then I would say they were stupid, but now I know from experience that they weren’t stupid, but I was deceived.”
This is because Spang, too, was allegedly “sucked” into the Noah / Rockwell mess by Hamrick.
“Just like other investors, I thought this was going to be a certain facility, and it was a complete sham.”
Spang did not join the trial, because unlike most litigants, his property – in Southfield, Michigan – was built and used as an event venue. So, although she filed a claim in bankruptcy court (she said it was in the low six figures), she said homeowners could get more by selling the property than through the court.
When asked to compare the FRM scandal to this one, Spang said the Noah / Rockwell program is much more important because it has national reach. And when asked if that might trigger legislation on her part, Spang, who focuses primarily on environmental issues, said she hoped some of her more financially savvy colleagues could take care of the matter. .
âI don’t know much about this stuff,â she said. âThat’s why I was duped. I was an innocent person.
Bob Sanders can be reached at [email protected]. These articles are shared by the partners of The Granite State News Collaborative. For more information, visit collaborativenh.org.
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