Negative Press for the 1031 Exchange Industry Raises Investor Awareness

           A couple of high profile defalcations by established qualified intermediaries have cast a negative pall on the 1031 exchange industry. Although such defalcations are extremely rare, a recent trend of consolidation in the industry has provided the opportunity for less than scrupulous operators to obtain ownership of qualified intermediaries with existing goodwill and strong referral sources. The investors using those intermediaries, and their advisors, apparently neglected to ask a few simple questions that would have alerted them to potential problems with the qualified intermediary. 

1.  Will I have any control over the exchange funds?

            If a taxpayer has unfettered control over the exchange funds, the exchange will fail. Alternatively, giving a qualified intermediary total control of exchange funds makes most taxpayer's queasy. The preferred and recommended solution is to have the funds deposited into a dual signature account that requires both the signature of the taxpayer and the qualified intermediary to transfer the funds. The amount of control provided by a dual signature account will not jeopardize the exchange as it does not rise to the level of the taxpayer being deemed in constructive receipt of the funds.

            Another measure of control is obtained if the taxpayer can converse directly with the financial institution where the funds are located and if the accounts can be viewed online. This provides a level of financial transparency in that the taxpayer can correspond directly with the financial institution or log into the website of the financial institution where the funds are being held to view its account.

2. Are my funds segregated in a separate, identifiable account?

            Some qualified intermediaries commingle all their exchange funds into one big account called a pooled account. Although this method may work for financially responsible intermediaries, the accounting requirements and the possibility of one bad transaction tainting the entire pool make pooled accounts a bad choice for taxpayers. For example, a bankruptcy court in Minnesota held that the commingled exchanges funds held by an intermediary were an asset of the intermediary, and not assets of the taxpayer's, and the funds were ultimately used to pay the general creditors of the intermediary.

            A taxpayer should insist that its exchange funds be held in a separately identifiable, segregated account. This account should be segregated from all other client accounts, and separate from the account of the qualified intermediary. The segregated account should be titled in the name of the taxpayer and the qualified intermediary as confirmed by the financial institution where the funds are being held.

3. Where are my funds being held and are they invested in a cash account?

            A taxpayer's funds can be at risk from forces beyond the control of the qualified intermediary if they are deposited with a weak financial institution. Most qualified intermediaries deposit their client's exchange funds with either large, national banks such as Bank of America, Citizen's Bank and Wachovia, or strong regional banks located geographically in the area where the taxpayer is exchanging.

            The exchange funds should be invested in highly liquid cash accounts. A 1031 exchange provides many taxpayer's with the ability to close a transaction quickly, and the funds need to readily available. Furthermore, a qualified intermediary should never invest the funds in any vehicle that would expose the same to market risks. For instance, the intermediary in the Minnesota Bankruptcy case lost the commingled exchange funds through day trading.

4. What is the reputation of the qualified intermediary and its owners?

             There are no licensing requirements for qualified intermediaries, and a taxpayer's funds could be at risk to an unscrupulous or reckless intermediary. It is essential, therefore, that a taxpayer does its homework before selecting a qualified intermediary. Questions to ask include: (i) how long has the company been in business, (ii) who are the owners and how long have they owned the company and (iii) does the company have the technical expertise to facilitate the exchange.

            A recent trend towards consolidation in the 1031 industry has created a problem. Qualified intermediaries with sterling reputations and substantial goodwill have been sold to purchasers who have ended up being less than scrupulous. Many of the clients and referral sources of these purchased intermediaries were unaware of the change in ownership, and therefore thought they were still dealing with the prior competent owners. For example, the purchaser of a series of intermediaries, including a Boston-based qualified intermediary originally owned and operated by local attorneys with stellar reputations, recently caused the intermediary to file for bankruptcy protection due to mismanagement and apparent loss of exchange funds. The lesson to be learned from the foregoing is that a taxpayer must determine the identity of the current owners, and then review the credentials and reputation of the current owners

5. Is the qualified intermediary bonded and insured?

                From an insurance prospective, the intermediary should have a fidelity bond to protect against theft or embezzlement, and an errors and omissions (E&O) policy to insure against losses resulting from an employee's negligence.

Conclusion

            In order to ensure the safety of its exchange funds, a taxpayer should first find a qualified intermediary that has a good reputation as gleaned from subjective data such as references and objective data such as the intermediary's participation in educational endeavors including seminars to tax, legal and real estate professionals, published articles and willingness to meet and discuss 1031 exchanges either in person or on the phone. The taxpayer should then determine the identity of the owners, and whether they have owned the intermediary for an extended period of time. After being satisfied that an intermediary is acceptable, the taxpayer should confirm (and insist) that its funds be held in a segregated, dual signature exchange account, with the exchange funds invested in a cash account with an appropriate financial institution. Finally, the taxpayer should ask whether the intermediary is bonded and insured.