(Dow Jones) A tax strategy that allows real estate investors to roll over capital gains from the sale of a property to a new one needs to be used with more caution these days.

The move, which can be used only for investment property, is perfectly legal and has been around for years. Some unscrupulous middlemen have abused it lately by using money they were holding for clients for their own purposes, sparking lawsuits and possibly more oversight as part of the federal overhaul of financial-services regulation.

Known as 1031 exchanges for the section of the Internal Revenue Code that allows them, the tax maneuvers ran into trouble through middlemen called qualified intermediaries who hold money for investors, and buy and sell property for them.
Edward Okun, a Miami businessman, was sentenced to 100 years in prison for running a Ponzi scheme to defraud clients of about $126 million through his firm, 1031 Tax Group LLC. Investors have managed to recover millions of dollars in various lawsuits over the exchanges, and more settlement discussions are under way in the Okun case.

The troubles have drawn attention to qualified intermediaries, who are largely unregulated, and prompted advisers to take new precautions. For now, anyone using a 1031 exchange will still have to work with a qualified intermediary, but should do it in conjunction with a qualified trust or qualified escrow account, according to Charles H. Egerton, a partner at Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A. in Orlando, Fla. The trust or account preferably should be with a third-party bank or trust company, Egerton says.

In the past, it was possible to use a qualified trust or escrow account, but most people avoided the added expense this involved. Most qualified intermediaries are reputable, and only a handful of them made illegal use of the strategy, according to Stanley L. Blend, practice group leader and shareholder at Oppenheimer, Blend, Harrison & Tate, Inc.

Still, anyone thinking of entering into a 1031 exchange may want to consider a qualified intermediary linked with a large financial institution. With these firms, "people feel like they have a lot of capital net worth standing behind them," Blend says.

New rules on 1031 exchanges are due from the Bureau of Consumer Financial Protection, which was created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, passed in July. The scope of those provisions isn't clear, but they might block qualified intermediaries from comingling investor money, as they did in the cases where abuses occurred.

Copyright (c) 2010, Dow Jones. For more information about Dow Jones' services for advisors, please click here.