Santa Barbara Politics, Media & Culture

Saturday, March 24, 2007

Qualified Intermediary or Common Thief?

(Please note: I made a few updates tonight (3/25) after finding out new information)

I read at The Santa Barbara Independent that local investors have lost almost $10 million when the fund of a local company, Qualified Exchange Services (QES), were found missing. This is likely part of a much larger scam involving perhaps $100 million in funds. I did some research and found that his is an unregulated industry that was set up to address the needs of the Internal Revenue Service's 1031 Tax Deferred Exchange. McGhan Medical Coporation (now Inamed) founder Don McGham has been charged with filing false financial statements.

The tax deferred exchange process is a way sellers of an investment property can sell their property and acquire a replacement property without seeing any taxable capital gain. In essence, the "qualified intermediary" (QI) holds the property between the sale and purchase of replacement property.

From what I understand, this business model is not structured to protect the customer. Although most QIs are honest and ethical -- and not all use this business model -- this is what can happen:

1) A QI can keep all or part of the interest on the funds held in between sale and purchase. There is no legal reason for this as the IRS allows customers to keep all of their interest. The IRS is considering changing this and taxing on the interest whether or not the QI is involved. (Update: actually the IRS is considering taxing the interest to the exchanger even if the QI keeps all or part of that interest. This would be a positive step for customers to become well aware of what
interest is earned on their funds).

2) Accounts are not segregated. QIs can mingle funds to maximize interest for themselves.

3) When accounts are not segregated, the risk of theft is greater. McGhan found that he could buy a QI and use the funds for his own purposes. Imagine using these funds to buy more QIs and having access to even more funds. Consider $10 million at 5.25% and you have monthly interest of $42,730.

I'm not an expert at this but it seems each of the sellers in this case have breached a fiduciary responsibility to their customers by giving up control of the funds they held without making sure they were protected. The customers have now lost their money and could not complete their exchange -- a double whammy from which they may not ever recover.

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Anonymous donaldo de Santa Barbara said...

So many pyramid schemes I recall many schemes, usually called pyramid schemes. Not in this case exactly but a rip off is a rip off. And schemes appear to be the basis of our economy. I know we don't really want to look at the real estate market but that is what it is...scam or scheme of earnings for doing absolutely nothing.

But then we set ourselves up for it. Those dreamy eyed Ronald Regan Republicans sold us all the bill of goods. Who needs "regulation." The "Marketplace" will solve any problems and if that doesn't work then your gun rights will be the back up.

And while this appears to be another case of personal corruption I couldn't imagine how this plays out with the youth. It seems to me that when another child is killed in the "Heart" of our city (rather than on the westside or eastside)perhaps looking in the mirror than for blame would be the appropriate response.

3/24/2007 3:58 PM  
Anonymous Eckermann said...

Unfortunately, someone who owns rental property and wants to exchange for another property of equal or higher value must use a QI to avoid capital gains. The whole reason why this tax scam exists is to provide incentive for people to invest in rental property, thereby providing afforable housing. Without the depreciation and exchange tax scams, rent would just be another taxable income for the property owner and the taxable appreciation of the property would be the only possible gain (which is a rather low percentage gamble). From what I have heard, most QIs are honest and conservative. But this is a financial practice that is crying out for regulation. Exchage funds should go into a secure and regulated escrow account to await disbursement to the new investment. Interest earned in escrow should be evenly distributed to the invester and escrow holder and taxed. This is so simple. The fact that it does not work this way leads one to believe that the foxes are firmly ensconced in the chicken coop, assigning the nests, setting the coop policies, and feasting on the eggs and the chickens at will.

3/24/2007 8:31 PM  
Anonymous Anonymous said...

Does someone who uses a QI retain their original Prop. 13 tax assessment too?

Gosh, I'd like to avoid capital gains taxes on my investments too. Can I get a QI to hold my mutual funds?

It all reminds me of the old phrase from the 60's... after the revolution, we'll make QI owners clean toilets with a toothbrush. Or perhaps better, we'll make them be care attendants for the young people who grew up in their apartments, and who were stabbed and paralyzed in gang fights.

3/25/2007 5:14 AM  
Anonymous Valerio said...

Well, this subject is the ultimate answer to amnesic critics of Blogabarbara that it only is about the Newspress Mess and Iya Falcone.

3/25/2007 11:14 AM  
Anonymous sa1 said...

It's a sad fact in our society that we don't show as much vehemence towards financial "white collar crime" as we do other non-violent crime. The damage done in many cases is severe and widespread. These perpetrators should be delt with as much severity as we deal with organized crime, drug offenders, looters et al. No bail, and confiscate all their property. Wall Street is also rife with this type of thievery. It's hard to overcome human nature when the gains are high and the risks/penalties are low. You know the "powerful" protect their own in many ways and the politicians are to busy sucking up to special interests to try and oppose them. One only has to look at how few prosecutions were made over the stock market meltdown in 2000-02. They are still digging up skeletons in that debacle but most get away with a slap on the wrist.

I don't know how we pierce the coporate veil, but if we don't do something soon, all the wealth in this country will be in the hands of a very few and we'll be just like Mexico, most of Latin America, the SE Asia, Russia, China and the others places where public and private corruption has become a way of life. It's a very scary world out there...

3/25/2007 3:11 PM  
Anonymous Essay Ole said...

Speaking of scary, I'm reading a debate in the local newspaper here in Roswell, NM about building a waste nuclear fuel reprocessing plant outside of town. Maybe we could put some of that highly educated talent to work if we got one of those...

In the last four days we've had thunderstorms, rain, hail, lightning strikes, flashfloods and thirteen tornados, no wonder the housing is so very affordable here! :-O

3/25/2007 5:02 PM  
Anonymous sa1 said...

I was once party to a 1031 and no, the prop 13 assessment doesn't transfer the only thing you escape is capital gains. We used a real estate attorney who held the funds in trust. I didn't even know there was such an entity as a QI till I read about the arrest of McGhan. I think thew bottom line is that you should get at least two opinions about how to handle these transactions if you're not very familiar with them. Same goes for tax schemes as the IRS is very unforgiving if the catch you doing the wrong thing.

3/25/2007 10:54 PM  

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