When it comes to Section 1031 (ten thirty one) tax-deferred real estate exchanges, investors are getting some decidedly mixed signals.

On the one hand, there have been a number of high-profile financial failures of exchange intermediary companies, the folks who hold your money while the exchange is underway, putting small investors at risk of losing some or all their cash.

On the other hand, smaller-scale, long-time exchange intermediaries insist their business models are safe for investors -- they're well insured and bonded and pose no risk of loss at all.

The recent bankruptcy filing of one of the country's largest exchange intermediaries, Land America 1031 Exchange Services of Richmond, Virginia, froze nearly $420 million in funds held by the company on behalf of 450 investor clients.

Exchange intermediaries hold funds generated by Section 1031 real estate swaps. IRS rules require some form of independent middleman because the tax code prohibits receipt of cash by exchangers seeking to defer capital gains taxes.

The problem posed by intermediaries is that, in the event they experience financial distress, they may file for bankruptcy protection and claim the right to use escrowed funds from ongoing exchanges to pay creditors.

In the LandAmerica case, the intermediary disputed investors' claims that the company was holding their money in trust - making it untouchable by creditors in a bankruptcy. A federal judge is still looking at the arguments, and a resolution may be months away.

Meanwhile, small-scale exchange intermediaries around the country continue to handle clients' funds with no losses. Bill Horan, co-owner and vice president of Realty Exchange Corp, based in Gainesville, Virginia, argues that, with due diligence, "investors can do 1031 transactions through qualified intermediaries with complete confidence," he told Realty Times last week.

In Littleton, New Hampshire, the firm of Edmund & Wheeler focuses on smaller and medium-sized real estate exchanges, and this month posted guidelines for investors on what to look for in choosing an intermediary - essentially how to avoid a middleman that could cost you pain, time and money.

Tops on the list: Look for extensive track records of successful exchanges, documented by references from investors. Make sure the intermediary has substantial insurance coverage to protect you - including bonding and errors and omissions. Check how the intermediary handles client funds.

Are exchange escrows deposited in a reputable, well capitalized bank? Does the intermediary commingle clients' funds or create separate, safer individualized accounts?

How accessible are top executives to you as a client? Can you get funds out quickly if you need to?

All good questions and advice for anyone contemplating a 1031 exchange in troubled times.

Published: February 27, 2009

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.