Real Estate & Property Law

1031 Exchange Firms Fail, Cost Investors

A number of successful real estate investors set for retirement are now scrambling to recover their money and facing big tax bills. The problem is, their assets reportedly were held by two so-called 1031 exchange companies that failed, leading to lawsuits and calls for regulation.

Among them is Marsha Slotten, 58, a real estate broker who placed $2.74 million from a strip mall sale with Southwest Exchange Inc., reports Bloomberg. Slotten planned to buy two drugstore buildings and live off the rental income. Now Southwest, based in Henderson, Nev., is in receivership, and Slotten not only can’t access her money but owes 15 percent capital gains tax on the strip mall sale. Her retirement, she says, is over, and she has returned to work.

Under a tax code provision known as section 1031, real estate investors can defer capital gains tax if they sell one property and purchase another through a qualified intermediary. Southwest and another Virginia-based exchange company that operated as qualified intermediaries recently went bankrupt, after company officials allegedly used real estate investors’ assets to establish personal businesses.

With “no barriers to entry … anybody can join the industry and hold other people’s money,” says Gary Gorman, founder of Denver-based 1031 Exchange Experts LLC. “At least when you get a massage or a haircut, you know they have to be licensed.”

But Mark S. Dzarnoski, a lawyer representing Southwest’s former chairman, says his client denies wrongdoing. “There were contracts, but there were no restrictions on what could be done with the money once it was obtained,” says Dzarnoski. “There’s a spectrum between throwing money on a gaming table and investing in government securities. McGhan’s use fell somewhere between those endpoints, and what’s going to be determined in court is whether or not that’s OK.”

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