New Law Makes Way for LKE Peace of MindBy Kim Phelan
Article Date: 09-01-2010
Copyright(C) 2010 Associated Equipment Distributors. All Rights Reserved.
Dealers using like-kind exchange as a cash flow strategy will soon be assured of a level playing field among qualified intermediaries, thanks to legislation that will develop federal regulation of the exchange accommodators’ industry.
Congress and the Obama Administration have taken steps this summer that will benefit equipment distributorships that utilize 1031 Like Kind Exchange (LKE) as a cash flow tool for turning their equipment rental fleets. On July 21, the president signed a financial reform bill into law that provides for the creation of a Bureau of Consumer Financial Protection that will be housed under the Federal Reserve – the new legislation requires that a director of this bureau be appointed, and his/her first order of business will be to conduct a study of the tax-deferred exchange transaction industry. The Bureau is then tasked with proposing legislation and/or regulations to protect consumers using exchange facilitators.
It’s good news for the LKE industry as a whole and for those who depend upon it, according to Brent Abrahm, president of Accruit, AED’s Preferred Provider of LKE Solutions.
“Billions of dollars go through this vehicle every year,” he said. “It’s important for dealers in a cash flow strategy like this to understand what’s going on in Washington and the regulations that are coming – in this case to put protections around it. It’s important that they understand this is still a very powerful and a very good strategy.”
The Dodd-Frank Consumer Financial Protection Act’s new bureau will become the vehicle whereby federal regulation of the exchange facilitator industry is instituted for the first time since LKEs were established in the tax code in 1921. The Federation of Exchange Accommodators (FEA), the professional trade association for qualified intermediaries under internal revenue code 1031, calls the Act a good start.
“This is a great beginning,” stated FEA President David Gorenburg, in a press release issued when the president signed the legislation. “However, there is much more work to be done to achieve our goal of comprehensive federal regulation that will cover all exchange clients and transactions.”
When equipment dealers place hundreds of thousands of dollars, and even millions, in proceeds from the sale of rental assets into the hands of qualified intermediaries (QIs) for safekeeping until replacement rental assets are purchased, they naturally expect 100 percent trustworthiness.
They expect the QI to be of unquestionable character and ethical standards, who will be a steward of their funds in full accordance with the IRC tax code. Section 1031 provides that these carefully documented revenues be safeguarded by an exchange accommodator until they are re-applied to the purchase of replacement assets for the business. One critical factor for taking advantage of this tax-deferral benefit is that funds must be assigned to a QI, who is entrusted to hold the dealer’s money appropriately – essentially with these basic objectives: (1.) protection of the principal and (2.) preservation of liquidity.
Why Regulate After 80 Years?
Until this year, no broad regulation has existed in the U.S. to ensure purity in QI investment activity on behalf of their clients. For years, the national association that represents QIs, the FEA, has sought to change that, actively pursuing federally mandated regulation of the exchange industry – in essence desiring transparency for their industry with a “rulebook” that would hold all QIs to the same standards. However, the FEA’s petitions were initially rebuffed by the federal government on the grounds that the burdens of national regulation would outweigh the potential benefits.
Undaunted by the federal rejection of QI regulation, the FEA worked diligently among state legislatures over the last three years and successfully saw eight states pass variations of its model law for exchange fund standards. Thanks to FEA’s efforts and countless volunteer hours from professionals like Abrahm, LKE is now state-regulated in California, Colorado, Maine, Idaho, Nevada, Oregon, Virginia and Washington.
But what about the remaining 42 states? What guarantees do they provide for ethics and investment standards among QIs handling like-kind exchanges?
“Our goal at the FEA was not to create a bunch of patchwork state regulations – that’s unmanageable,” said Abrahm. “We’d have to administer 50 individual states with their own individual tweaks on the FEA’s model law. Our interest has always clearly been to get federal regulation.” Abrahm is not only a board member of FEA, but co-chairs the associations’ State Regulatory Committee, is a member on the Federal Regulatory Committee, and is FEA’s president-elect for the 2010-2011 year.
The turning point for achieving success at the federal level may unfortunately be attributed to the occurrence of wrongdoing. Over the last few years, incidents of defalcation – when a QI misappropriates clients’ funds by reckless investment, negligence, or perhaps loaning of client money to other subsidiaries of its company – have brought LKE a bit more into the limelight, if not under the microscope. Legislators began paying more attention to the interests of taxpayers, although lawmakers have not necessarily demonstrated thorough comprehension of the use of LKEs, despite having passed a legislation that will govern them.
For example, language in the Consumer Financial Protection Act presently addresses exchanges for personal, family or household use. The problem, says Abrahm, is that’s not who uses like-kind exchange; even the written tax code makes it clear the LKE 1031 is for business use.
“You get to a point where you say, ‘We’re OK with this, we can change some of the language later,” said Abrahm. “Given the fact that there’s going to be a study, we can now work on further clarification during that process. We as an association like the concept of putting a study on this. What it’s showing is there is a move toward regulation for QIs and exchange facilitators; we’ll now work on the appropriate language to encompass businesses.”
Because FEA is the only trade association for the exchange accommodator industry, the government naturally relies on the group for guidance in understanding what it is, exactly, that needs regulating. With a strong lobbying presence in Washington and active volunteer members, FEA is closely tied in to all LKE decisions and will be active in developing the methodology of the study. The findings of the study will then lead to the specifics of what will be federally mandated.
Among the particular facets of LKE that ought to be federally regulated, perhaps the No. 1 issue, according to Abrahm, is fund management practices. Specifically, FEA promotes short-term investments such as savings/passbook accounts, demand-deposit accounts, or money markets held in qualified escrow or trust accounts.
“1031s are not investment vehicles,” he said. “They’re not intended as a means for people to make money on their investments; they are designed to protect the principal to allow it to be reinvested in replacement property. You want these investments to be highly liquid, so you don’t want something to be in a 90-day treasury bill or a CD. They need to have assets that are liquid upon call – that’s very important.”
Another important element of fund management that FEA wants in the federal policy is the need for keeping client exchange funds completely segregated. “You cannot commingle funds with your operating account, and QIs have done that in the past – just one big pot of money,” said Abrahm. “It must be mandated that you cannot do that; you cannot send that money to affiliate businesses. Those funds are held specifically for replacement property, and specifically on behalf of the taxpayer.”
Even though the FEA advocates tight regulation in the area of prudent investment standards, Abrahm adds the caveat that he favors client choice when the investment mode is determined. Dealers, for example, ought to have a voice in how and where their tax-deferred funds are invested – as long as the investment vehicle meets the criteria of protecting the principal and preserving liquidity. Abrahm says Accruit’s clients frequently articulate their preferences, and he believes it should remain that way.
“I hesitate to cross over to an area where we’re telling taxpayers, ‘This is the only investment you can go into.’ Choice and transparency are both critical.”
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