One area of my research involves payment systems and the role of financial intermediaries in fulfilling various government functions, including tax and criminal enforcement. When we use banks or credit card networks to pay others, we create electronic records that can be accessed by the government for various purposes. (The same is true when we use our cell phones, but encryption may make it difficult to access such information – a problem unfolding in the current controversy with Apple.)
Anti-money laundering (AML) rules impose some obligations on financial intermediaries to identify their customers, know something of their business, and report suspicious transactions. Tax reporting rules also require tracking and reporting of certain kinds of payments – including interest, dividends, and other revenue sources. This allows the government to “trust, but verify” positions taken by its citizens, ensuring that our voluntary tax reporting system remains functional.
Cash presents special problems. In some ways, cash is inferior to electronic forms of payment. Among other things, cash presents a real security risk. Carrying it around makes us vulnerable, and if we have a lot of it, we have to carry suitcases full to be able to make payments. Electronic payments are more convenient and secure in this way. Moreover, some forms of payment, including credit cards, provide goodies to consumers, including miles, points, cash back, and other incentives, which cash does not provide. They also provide dispute resolution services, in the event that there are fraudulent claims against our accounts. Checks and wire transfers also provide some security, particularly before clearing, in that the intermediary may bear some responsibility for errors, which can be corrected in favor of the customer. But once cash has left the possession of the owner, a new owner emerges for all practical purposes.
Cash delivers one important benefit, however, and that is autonomy to pursue transactions without creating a digital record. If you value privacy for its own sake, or if you value privacy because you want to circumvent criminal or tax laws, cash is king. (Crypto-currencies, like Bitcoin, are also emerging – but we will cover these in a later post.) Governments know this, and thus they focus considerable attention on other money laundering rules, including those which attend deposits or payments of large amounts of cash. So, those criminal enterprises that generate large amounts of cash, including narcotics organizations (or even tax-evading cash-based businesses), find themselves with a problem: what can we do with all of the cash we generate? (Those fans of Breaking Bad have seen this problem emerge, as Walter White buries garbage cans full of cash in the desert.)
Recently, the Financial Crimes Enforcement Network (FinCEN) announced a new rule designed to address one facet of this problem: cash-based real estate transactions. It turns out that in major cities like Miami and New York, people have been paying cash for real estate. Instead of borrowing the purchase price, which would be a common practice for ordinary citizens, the purchaser avoids the usual privacy intrusions imposed by lenders. And instead of a wire transfer traceable within the banking system, they bring a suitcase full of cash.
But title to real estate must be held by someone – so isn’t that a big giveaway of the source of the cash? Actually, not if you use an LLC to hold that real estate. The laws of most states permit these entities to be legitimately formed without any public disclosure of the identity of the beneficial owners. If the entity wants to open a bank account, AML regulations will impose an obligation on the bank to ascertain the identity of the owner. But if you have cash, you don’t need a bank account. If you are the seller, your large cash deposit will generate a currency transaction report, but you have a good reason for the deposit, no? By wrapping the real estate inside an LLC, the purchaser gains some privacy – and potentially creates the prospect of bringing funds back into the legitimate economy.
FinCEN is targeting transactions in Miami and New York by requiring an intermediary – real estate title insurance firms – to ascertain the identity of beneficial owners in a cash transaction. According to news reporting by Bloomberg, this is potentially hurting demand for luxury real estate in Miami and New York, potentially driving customers to other countries. See Carmiel & Gopal, Luxury Home Market Seen Threatened by Transparency in NYC, Miami, www.bloomberg.com/news/articles/2016-01-14. However, it may also spawn new roles for intermediaries who wish to be the public face of the LLC. See id. (quoting a source that “there’s not much that you can do” about such problems).
Such rules are likely to be overbroad, in that they will also deter some legitimate transactions. For example, a celebrity may want to avoid attention from the prying eyes of the public, with nothing in particular to hide from the government. And since these efforts target only certain cities, perhaps they will simply displace purchases to other parts of the U.S., rather than driving purchasers abroad. And it may also displace the most rigorous title insurance companies in favor of those who have lower standards for checking on the identity of the true owner. The system is only as strong as the weakest link, particularly when it involves conscripting participation by the private sector. There may be some interesting developments emerging here which could make for a useful economic experiment to test the true effects of such a rule.