Retirement funds vanish as bankruptcies hit tax-deferred scheme
Monday, 17 September 2007
Erik Larson
Marsha Slotten's bad news came in April by e-mail, from a tipster warning that the company holding her retirement nest egg had collapsed.
After racing in a panic to the office of Southwest Exchange Inc. outside Las Vegas, she found a locked door and a sign saying the staff was ``in training.'' It never reopened.
``I was devastated,'' said Slotten, 58, who said she was forced to cancel early retirement after the disappearance of $2.74 million she made selling a strip mall. ``I thought I knew what I was doing, but now my nest egg, my retirement plan, is gone.''
The real estate broker is among hundreds of investors who lost the proceeds of property sales because two companies went bankrupt during criminal investigations.
The two were among thousands of mostly unregulated U.S. firms that hold money between commercial-property sales. Their collapse led to dozens of lawsuits and calls for regulation.
The intermediaries are known as 1031 exchanges, named for a provision of U.S. tax law that defers capital gains taxes if the seller of a property buys another like it within six months.
Exchanges are used by Fortune 500 companies, partnerships, individuals and investment trusts. More than 338,500 sellers deferred $73.7 billion in taxes in 2004, the latest year for which Deloitte & Touche LLP has data, the accounting firm said.
Transactions must be handled by so-called qualified intermediaries like 1031 exchanges, which have temporary custody of about $150 billion a year, an industry group says. They are unregulated in all but one state.
The bankrupt firms' owners are accused of using client funds to invest in other businesses, emptying bank accounts of more than $250 million. No criminal charges have been filed.
Investors' claims range from tens of thousands of dollars to more than $20 million.
Southwest Exchange, based in Henderson, Nevada, was forced into liquidation owing customers about $100 million. It went into receivership after the federal and state authorities started investigating its handling of clients' assets.
Ex-Chairman Donald K. McGhan is accused in a lawsuit of carrying out a plan to buy Southwest Exchange and use its deposits to finance the expansion of his MediCor Ltd., a Las Vegas-based maker of breast implants now in bankruptcy. Creditors of MediCor and Southwest Exchange may wage a court fight over the proceeds of a Sept. 18 auction of MediCor's assets.
McGhan's lawyer Mark S. Dzarnoski said his client denies any wrongdoing, noting there was ``no regulation'' over what could be done with the funds.
``There were contracts, but there were no restrictions on what could be done with the money once it was obtained,'' Dzarnoski said. ``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.''
The U.S. Attorney's Office in Richmond, Virginia, began a preliminary investigation of the second company, 1031 Tax Group LLC, after it couldn't return $151 million to more than 300 investors, chief restructuring officer James Lukenda said in court papers in May when it filed for bankruptcy in New York.
Clients accused founder Edward Okun of using their money to finance his own real estate ventures. Okun said in Bankruptcy Court papers he borrowed the money to invest in businesses and ``activities of entities he owned and controlled.'' His lawyer Howard J. Berlin didn't return a call seeking comment.
A judge in Manhattan next month will consider 1031 Tax Group's plan to liquidate Okun's real estate holdings and pay investors.
Even those lucky enough to get reimbursed for their lost sale proceeds almost all missed the six-month deadline and will owe the 15 percent tax they sought to defer. Okun's lawyer Norman Kinel is preparing to defend suits against 1031 Tax Group over the tax payments, according to court papers.
Most customers, including Slotten, also lost the chance to buy property they sought. She planned to acquire two new buildings housing Walgreen Co. drugstores and live off the revenue. Instead, she returned to her job as a real estate broker and is taking finance classes to enter a new field.
Exchange companies became popular during the mid-1990s after Congress streamlined the deferral law. They typically charge fees of about $500 to $1,500 per transaction and take a share of the interest earned on the money they're holding. Some are paid incentives by banks for opening new accounts.
Tax-deferral services are provided by institutions ranging in size from banks such as Wachovia Corp. and JPMorgan Chase & Co. to single-owner 1031 exchanges.
The Nevada and Virginia bankruptcies prompted calls for federal and state regulation. Nevada, the only state with such rules in place, increased its oversight.
``The problem has put a pall over these types of transactions,'' said Michael Machado, a California state senator who proposed state regulation to prevent bilking of investors.
On Aug. 6, the Federation of Exchange Accommodators, a national industry organization, petitioned the Federal Trade Commission to write nationwide rules for 1031 exchanges.
``It certainly concerns us that two companies are giving everyone in the industry a black eye,'' the Philadelphia-based federation's president, Hugh Pollard, said in an interview.
His group's code of ethics says members should ``keep the exchange proceeds in a stable financial institution or other reliable investment program unless the client expressly requests an alternative investment.''
``Federal regulation would definitely be good for the industry,'' said Mary Cunningham, president of Chicago Deferred Exchange Co., which handles $20 billion to $30 billion a year. ``We've done a very good job of self-regulating for the past 20 years, but a few dishonest people have sprung up.''
FTC spokesman Mitchell Katz said the agency ``will review the petition and give it due consideration before responding.''
The industry has ``no barriers to entry, so anybody can join the industry and hold other people's money,'' said 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,'' Gorman said.
The New York bankruptcy case is In re The 1031 Tax Group LLC, 07-11448, U.S. Bankruptcy Court, Southern District of New York (Manhattan). Southwest Exchange customers have made claims in the MediCor case, In re MediCor Ltd., 7-10877, U.S. Bankruptcy Court, District of Delaware (Wilmington).
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Marsha Slotten's bad news came in April by e-mail, from a tipster warning that the company holding her retirement nest egg had collapsed.
After racing in a panic to the office of Southwest Exchange Inc. outside Las Vegas, she found a locked door and a sign saying the staff was ``in training.'' It never reopened.
``I was devastated,'' said Slotten, 58, who said she was forced to cancel early retirement after the disappearance of $2.74 million she made selling a strip mall. ``I thought I knew what I was doing, but now my nest egg, my retirement plan, is gone.''
The real estate broker is among hundreds of investors who lost the proceeds of property sales because two companies went bankrupt during criminal investigations.
The two were among thousands of mostly unregulated U.S. firms that hold money between commercial-property sales. Their collapse led to dozens of lawsuits and calls for regulation.
The intermediaries are known as 1031 exchanges, named for a provision of U.S. tax law that defers capital gains taxes if the seller of a property buys another like it within six months.
Exchanges are used by Fortune 500 companies, partnerships, individuals and investment trusts. More than 338,500 sellers deferred $73.7 billion in taxes in 2004, the latest year for which Deloitte & Touche LLP has data, the accounting firm said.
Transactions must be handled by so-called qualified intermediaries like 1031 exchanges, which have temporary custody of about $150 billion a year, an industry group says. They are unregulated in all but one state.
The bankrupt firms' owners are accused of using client funds to invest in other businesses, emptying bank accounts of more than $250 million. No criminal charges have been filed.
Investors' claims range from tens of thousands of dollars to more than $20 million.
Southwest Exchange, based in Henderson, Nevada, was forced into liquidation owing customers about $100 million. It went into receivership after the federal and state authorities started investigating its handling of clients' assets.
Ex-Chairman Donald K. McGhan is accused in a lawsuit of carrying out a plan to buy Southwest Exchange and use its deposits to finance the expansion of his MediCor Ltd., a Las Vegas-based maker of breast implants now in bankruptcy. Creditors of MediCor and Southwest Exchange may wage a court fight over the proceeds of a Sept. 18 auction of MediCor's assets.
McGhan's lawyer Mark S. Dzarnoski said his client denies any wrongdoing, noting there was ``no regulation'' over what could be done with the funds.
``There were contracts, but there were no restrictions on what could be done with the money once it was obtained,'' Dzarnoski said. ``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.''
The U.S. Attorney's Office in Richmond, Virginia, began a preliminary investigation of the second company, 1031 Tax Group LLC, after it couldn't return $151 million to more than 300 investors, chief restructuring officer James Lukenda said in court papers in May when it filed for bankruptcy in New York.
Clients accused founder Edward Okun of using their money to finance his own real estate ventures. Okun said in Bankruptcy Court papers he borrowed the money to invest in businesses and ``activities of entities he owned and controlled.'' His lawyer Howard J. Berlin didn't return a call seeking comment.
A judge in Manhattan next month will consider 1031 Tax Group's plan to liquidate Okun's real estate holdings and pay investors.
Even those lucky enough to get reimbursed for their lost sale proceeds almost all missed the six-month deadline and will owe the 15 percent tax they sought to defer. Okun's lawyer Norman Kinel is preparing to defend suits against 1031 Tax Group over the tax payments, according to court papers.
Most customers, including Slotten, also lost the chance to buy property they sought. She planned to acquire two new buildings housing Walgreen Co. drugstores and live off the revenue. Instead, she returned to her job as a real estate broker and is taking finance classes to enter a new field.
Exchange companies became popular during the mid-1990s after Congress streamlined the deferral law. They typically charge fees of about $500 to $1,500 per transaction and take a share of the interest earned on the money they're holding. Some are paid incentives by banks for opening new accounts.
Tax-deferral services are provided by institutions ranging in size from banks such as Wachovia Corp. and JPMorgan Chase & Co. to single-owner 1031 exchanges.
The Nevada and Virginia bankruptcies prompted calls for federal and state regulation. Nevada, the only state with such rules in place, increased its oversight.
``The problem has put a pall over these types of transactions,'' said Michael Machado, a California state senator who proposed state regulation to prevent bilking of investors.
On Aug. 6, the Federation of Exchange Accommodators, a national industry organization, petitioned the Federal Trade Commission to write nationwide rules for 1031 exchanges.
``It certainly concerns us that two companies are giving everyone in the industry a black eye,'' the Philadelphia-based federation's president, Hugh Pollard, said in an interview.
His group's code of ethics says members should ``keep the exchange proceeds in a stable financial institution or other reliable investment program unless the client expressly requests an alternative investment.''
``Federal regulation would definitely be good for the industry,'' said Mary Cunningham, president of Chicago Deferred Exchange Co., which handles $20 billion to $30 billion a year. ``We've done a very good job of self-regulating for the past 20 years, but a few dishonest people have sprung up.''
FTC spokesman Mitchell Katz said the agency ``will review the petition and give it due consideration before responding.''
The industry has ``no barriers to entry, so anybody can join the industry and hold other people's money,'' said 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,'' Gorman said.
The New York bankruptcy case is In re The 1031 Tax Group LLC, 07-11448, U.S. Bankruptcy Court, Southern District of New York (Manhattan). Southwest Exchange customers have made claims in the MediCor case, In re MediCor Ltd., 7-10877, U.S. Bankruptcy Court, District of Delaware (Wilmington).
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