Today’s Auditing Moment: Rental Real Estate Transactions and Money Laundering. (Part 1)

CPAs that perform audits of financial statements under the Codified Generally Accepted Auditing Standards are typically well versed in the standards and practices detailed therein but to the extent continuing education on the topic of auditing often focuses on notable audit failures such as those involving ENRON and Mississippi’s own WorldCom along with a host of others dating back to the 1920s the study of what went wrong is both natural and needed.  Out of the ENRON and WorldCom disasters came a host of new auditing standards. I particularly thought the AICPA did a good job with AU Sections 314, 316 and 317 which deal with understanding the entity in question, and the risks associated with the entity including fraud and illegal acts.

Today, the realities of the post Katrina Mississippi coast is the growth of the rental real estate in terms of sheer number of units, often built solely as a result of post Katrina taxpayer subsidies.  The number of units constructed has resulted in a market overcapacity and that in turn impacts the monthly price of the rentals.  With insurance sky high the top and bottom line squeeze on the owners of the units can lead to pressure to do some very unsavory things. Let’s begin with the National Association of Realtors Anti Money Laundering page:

The crime of money laundering continues to be a growing area of concern in the United States. Therefore, law enforcement agencies and the financial sector devote considerable time and resources to combatting these illegal financial activities. However, many non-financial businesses and professions are also vulnerable to potential money laundering schemes.

Real estate professionals are a category of the non-financial business sector that may encounter persons engaging in money laundering activities. The purpose of this fact sheet and suggested voluntary guidelines is to increase real estate professionals’ awareness, knowledge, and understanding of the potential money laundering risks surrounding real estate and enable them to identify practical measures to mitigate the risks.

It is at this point that I’ll observe that while most people understand the concept of money laundering in a general sense they do not understand the specific elements so here it the skinny:

The actual process of money laundering is a three step process that is initiated by introducing the illegal proceeds into the financial system, e.g., breaking up large amounts into small deposits or by purchasing financial instruments, such as money orders, which is referred to as placement. This is typically followed by distancing the illegal proceeds from the source of the funds through layers of financial transactions, referred to as layering, and finally by returning the illegally derived proceeds to the criminal from what appears to be a legitimate source, known as integration.

So there we have it folks, money laundering is a three step process defined by 1. Placement 2. Layering and 3. Integration but this is different from the legal definition of the crime of money laundering. Here in the US, I find the FBI primer page on the topic to be very useful because in the US the crime of money laundering is just a 2 step process:

Simply put, money laundering entails taking criminal profits and moving them in a prohibited manner.1 Specifically, criminals or persons acting on their behalf generate proceeds in the form of money or property as a result of committing a crime designated as a specified unlawful activity (SUA).2 Criminals then move that money, often with the intent to disguise the nature, location, source, ownership, or control of the funds, which is known as “concealment” money laundering.3 Alternatively, in “promotion” money laundering, they reinvest the money in their criminal activities. Either theory suffices for a money laundering charge.4

Fortunately, most profit-based crimes are designated as SUAs. Thus, the movement of any of those SUA proceeds either to conceal them or to promote the same or a different SUA will provide the foundation for a money laundering charge. Investigators do not need to prove that the money launderer knew of the specific SUA from which the proceeds were generated. Rather, all that need be proven is that the person laundering the money believed it was dirty. Often, this permits investigators to prove the knowledge element entirely through circumstantial evidence by showing that the launderer received or handled the money in a way different from an innocent money transfer.5 (Emphasis added)

So what you find out in the “real world” here in the US is that once the SUA is proven the other element needed to prove the crime has a fairly low bar.  And it is serious business which is why the National Association of Realtors has that anti money laundering page. Here is what they advise their members that handle real estate transactions:

Know Your Business
Every broker and agent should be aware of certain characteristics of a real estate transaction that may be indicative of illegal financing activities. A real estate agent’s familiarity with the normal course of business will help them to identify any unusual or suspicious patterns. Law enforcement, regulators and the international community have identified multiple money laundering risk factors. In general, these risk factors (red flags) can be grouped in the three categories: country/geographic, customer, and transaction risk.

The realtors identify 3 broad risk factors. Let’s drill down on each:

Geographic Risk:

Geographic risk may arise because the customer and/or the source of the customer’s funds are located in a jurisdiction that has a weak AML regime, supports or funds terrorism, or has a high degree of political corruption. Although there is no definitive list of such jurisdictions, one good source is the list of jurisdictions subject to sanctions of the Office of Foreign Assets Control (OFAC) of the U.S. Treasury Department. OFAC administers and enforces economic and trade sanctions based on U.S. foreign policy and national security goals.

Customer Risk:

• Location of property in relation to the buyer.
  • Is there a large unexplained geographic distance between the two?
• Unusual involvement of third parties.
• Titling a residential property in the name of third party; for example, a friend, relative, business associate, or lawyer. Use of legal entities (corporations, LLCs or partnerships) that obscure the identity of the person who owns or controls them without a legitimate business explanation.
• High-ranking foreign political officials or their family members. (Emphasis added)

Transaction Risk:

• Under or over-valued properties.
• Use of large amounts of cash.
• Property purchases inconsistent with the individual’s occupation or income.
• Immediate resale of the property.
  • Especially if the sale entails a significant increase or decrease in the price compared to the prior purchase price, without a reasonable explanation.
• Speed of transaction (without reasonable explanation).
• Unusual source of funding.
  • Example: use of third-party funds to purchase a property where it doesn’t make sense, i.e. third-party is not a parent, sibling, etc., use several different sources of funds without logical explanation, funding coming from a business but property not being held in business’ name, or purchase of property doesn’t match the business’ purpose. (emphasis added)
• Purchases being made without viewing the property, no interest in the characteristics of the property.
• Any other activities which demonstrate suspicious behavior and do not make professional or commercial sense based on the agent’s familiarity with the real estate industry and the normal course of business.

For a seasoned business person these bullet points all make sense and can be boiled down to simply knowing the party with whom you are doing business and not even necessarily on a personal basis though that certainly helps greatly. One can otherwise get that knowledge via due diligence in checking third party sources, credit records etc.

Finally, for auditors doing independent reviews of rental real estate transactions it helps to know where the risk lies.  For that, let’s visit with the Financial Crimes Reporting Network and their publication titled Money Laundering in the Residential Real Estate Industry as the table on Page 15 (PDF page 18) shows that the greatest risk lies with the proverbial “unaffiliated individual” to the original criminal activity or in FBI speak “specified unlawful activity”.

This is what the Financial Crime Reporting Network had to say about the prevalence of criminal activity in one strata of the population:

Individuals unaffiliated with the residential real estate industry were found to account for over 75 percent of the entities involved in residential real estate related structuring and/or money laundering, as reported in the narratives of the 151 relevant SARs. This result may be attributable to the relative ease with which an individual may launder money through residential real estate without the need to have any formal affiliation with the industry.

When an entity uses straw buyers, for example, the money launderer need only find employed individuals willing to accept a fee to allow their identities to be used to apply for residential real estate loans. The straw buyers’ bank account can then be temporarily funded by the money launderer prior to application for the loan. In many cases, the mortgage company will determine that the applicant is employed and has sufficient savings in the bank to qualify for the loan. In instances where the launderer himself controls legitimate or front companies or has associates that do, it may be possible to also falsify the applicant’s level of income and employment status. Once the loan is approved and funded, the launderer moves the money out of the straw buyer’s account and may move it into another straw buyer’s account to repeat the process. The loan payments are made by the launderer on a timely basis using illicit funds. As is often reported in SAR narratives that describe money laundering generally, payments may be made in the form of money orders or other negotiable instruments, which in this scenario may bear the name of the straw buyer, or may be in the form of automatic debits from the straw buyer’s bank account, which is controlled by the launderer.

Previous research has indicated that when funds are layered through accounts, an individual not employed by a real estate-related entity may nonetheless work in concert with a corrupt real estate entity to launder illicit funds. A money launderer may convert illicit cash into negotiable instruments, including those purchased by others, which may then be deposited to personal and/or non real estate-related business accounts, and layered through the accounts of complicit residential real estate-related companies disguised as legitimate payments for real property or real estate-related services.

I would submit that while the FCRN report deals with residential real estate transactions its findings apply across the entirety of the rental real estate industry.  For instance a roach motel that rents rooms by the hour is just as engaged in money laundering as the instances above that use banks as financial intermediaries.  We’ll explore that a bit more in part 2.

Finally, in researching this topic I was amused to find that even the Ukrainian Government had an internet resource on the use of fictitious real estate operations in money laundering. The translation is rough but the general idea is still well conveyed in their Example IV:

Example ІV[4]. Use of fictitious real estate operations

Mr. C residing in Ukraine has received to his account in Ukrainian bank over 7 mln. hryvnas from enterprise-resident of Ukraine allegedly for selling house he possessed. While carrying out more precise analysis, it was discovered that passport, presented on behalf of Mr. C while both conducting purchase agreement and transferring money, was claimed lost.

As it was additionally determined in State Register of real estate property rights – there was found no information about Mr. C’s ever possessing a real estate. Also no information about registration of property rights for the purchased real estate by Ukrainian resident was found.

Considering the received information on absence of any real estate, privately owned by Mr. C, there are reasonable grounds to believe that funds, received by the mentioned person from enterprise, are illegally acquired.

Possible suspicions:

• use of lost, fabricated person ID.
• origin of funds, involved in real estate operations is unknown;
• the customer is entity with insignificant activity period (as a rule such term is under 3 months since registration);
• real estate purchasing agreement is absent;
• property rights for the object of purchasing are absent;
• information in purchase agreement is inconsequent or inadequate;
• purchase agreement is legally incapable.

Instruments:
– wire transfers;
– fictitious real estate transactions;
– lost, fabricated person’s ID.

Mechanisms and methods:
– client bank accounts, involved in fictitious real estate transactions.

Stay tuned.