Filing raises fears about tax shelter

A real estate market under siege from subprime mortgages and the credit crunch could be hit with another twist.

The bankruptcy case in Richmond of LandAmerica 1031 Exchange Services Inc. might harm the market for a key tax shelter used by people who buy investment properties.

The consequences could reach far beyond central Virginia and the 450 customers of the now-closed exchange, which is a subsidiary of Henrico County-based LandAmerica Financial Group Inc.

The investors, many of them individuals who have significant portions of their savings entrusted to LandAmerica, have had their funds frozen for months and could see them consumed by the bankruptcy. The taint on the exchange-services industry could further chill an already moribund real estate market.

"This is endemic and nobody did anything or is apparently very enthusiastic to do anything about it," said Peter Schonberger, a LandAmerica customer from New York who placed $180,000 with the company. "Nobody gives a whit about the small investor."

At least 300 companies such as LandAmerica offer exchange services that allow investors to avoid capital-gains taxes on investment-property transactions by giving them a place to park the proceeds until they purchase another property. Nationwide, more than $150 billion is funneled through such unregulated exchanges each year.

Funds in these escrow accounts are supposed to be liquid, so clients can get their money at any time.

However, LandAmerica invested some exchange money in auction-rate securities, which once were considered safe investments. But that market froze up in February, making the securities impossible to sell.

LandAmerica and its exchange subsidiary declared bankruptcy Nov. 26. At the time, it had $383.6 million in exchange funds.

Seventeen lawsuits have been filed against the LandAmerica exchange, all claiming breach of contract, seven claiming fraud, four malicious representation and several seeking damages.

It's not the only exchange in financial trouble.

On Dec. 15, Summit 1031 Exchange Inc. in Austin, Texas, citing a shortfall in the balance of exchange funds, curtailed daily operations, ceased funding exchanges and stopped accepting new ones. It declared bankruptcy four days later.

The industry is watching LandAmerica and other exchanges as nervous investors wonder if they will ever be made whole.

"Everyone thinks money placed in escrow is safe from the claims," said Bradley T. Borden, a professor at Washburn University School of Law in Topeka, Kan., who has studied the exchange industry. "With this litigation going on now, people don't know how to advise customers."

The question before the bankruptcy court: Is the money in LandAmerica exchange services part of the bankruptcy pool of money to be distributed to all creditors?

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The failure of LandAmerica 1031 Exchange Services poses myriad problems for its investors. Not only did they lose access to their funds, it's unclear whether they will ever get their money.

If they can't get the money and reinvest it within 180 days of when they sold their initial investment, they must pay taxes on any capital gains.

What's more, they can lose their deposits on other properties if they can't complete the deal.

Magnify that scenario by the unknown thousands of investors involved in exchanges and the investment real estate market could take a significant hit, industry experts say.

"A lot of people are losing sleep," said Craig Wolfe, a partner with Kelley Drye & Warren, a New York law firm representing two family-owned businesses that invested $36 million through LandAmerica.

Wolfe's clients have their money in segregated or individual accounts. In all, 50 of LandAmerica's 450 exchange clients at the time of the bankruptcy had their money in segregated accounts. Investments from other investors are commingled -- held in a single account.

Wolfe argued before the bankruptcy judge in Richmond Dec. 16 that money in segregated accounts is held in trust by LandAmerica and should be released.

"There is a powerful argument that commingled money may not be held in trust," he said.

But the investors with money in commingled accounts claim their money is held in trust, too, and should be given the same treatment as individual accounts.

"There are 400 people out there who desperately need their money and they thought LandAmerica was just holding it for them," said Rich Maxwell, an attorney with Woods Rogers in Roanoke who is representing people whose money is commingled.

The unsecured creditor's committee wants all the money -- segregated and commingled -- to be part of the money to be divvied among creditors.

"There's a chance for a significant recovery for everyone," said Charles R. Gibbs, counsel for the unsecured creditors' committee with Akin Gump Strauss Hauer & Feld in Dallas.

The issue is far from clear; no ruling has been made. The next hearing is set for Jan.12.

"Delays are creating uncertainty," Wolfe said. "We are confident that segregated accounts will end up being released, but the fact that it will take six weeks, maybe two months is jeopardizing the industry."

. . .

Vivian Hays said LandAmerica assured her that her money was secure.

"I was never told that all my funds would be invested, especially in already frozen assets, or commingled in a general account," she said.

Hays sold a building in California that she had owned since 1984. The proceeds, $383,913, represent her entire business net worth, she said.

Hays said she planned to invest in a triplex near where she lives in Hayden, Idaho.

"It's my source of income," she said. "I'm a single woman, 55 years old, a survivor of breast cancer. . . . My income is gone. My building is gone. My money is gone.

"And I will be held liable for capital gains, which will be huge because the building was old and had been depreciated."

Exemptions for paying the capital-gains tax are allowed only after a presidential-declared emergency, such as a natural disaster, occurs, according to the IRS. "A blown deadline is a blown deadline," an IRS official said.

Hays said she checked company financials and asked questions. "I was told [the money] would be held in trust and that my funds would be completely liquid."

She said she invested her money with LandAmerica five days before it declared bankruptcy. "It was blatant money grabbing."

The company should have told customers that it was unable to honor the contracts, Hays said.

Goochland County residents Tom and Kellie Lineberry put money from an investment property into the LandAmerica exchange with plans to buy a development in Nags Head, N.C.

Not having access to the funds is crippling their purchase, Tom Lineberry said.

"[LandAmerica Exchange Services] unconditionally guarantees the return and availability of the exchange funds," according to the agreement he signed.

A LandAmerica spokeswoman declined to comment, saying the issue is in litigation.

. . .

LandAmerica was the third-largest title insurer in the country, a Fortune 500 company and listed in the magazine's 2006 list of America's most admired companies. Its roots in Richmond go back to 1925 as Lawyers Title Insurance Corp.

"Up until a month ago, no one was more financially sound and reliable than LandAmerica . . . then boom, within a few months, it's out of business," said Steve Gentil, chairman of Grubb & Ellis/Harrison & Bates, a commercial real estate company in Richmond.

Rising real estate prices in the five years leading up to 2008 created a huge wave of 1031 exchanges, Gentil said. "They were second nature. You didn't think for a second about whether the money was safe."

A pamphlet from LandAmerica's 1031 guaranteed a 100 percent security for all accounts.

"The vast majority of qualified intermediaries provides no protection, guarantee or security for these net proceeds," according to the pamphlet. "LandAmerica 1031 Exchange Services is different."

Eric Brecher, an attorney for Washington Mutual in New York and a certified exchange specialist, said some people choose to invest in riskier exchanges to earn more interest, but that is not the intention of a 1031 exchange.

"It's not an investment account," he said. "It's about deferring taxes."
Contact Carol Hazard at (804) 775-8023 or .

Contact Emily C. Dooley at (804) 649-6016 or .