Protecting Your 1031 Exchange Funds - QI Due Diligence

This is the third part of a series of articles published to inform exchangers how to protect their sales proceeds in a 1031 exchange.

           In almost every state, anyone can set up shop as a qualified intermediary. There are no licensing requirements, criminal background checks or other safeguards to protect exchangers from unscrupulous or reckless intermediaries. Accountants, attorneys and realtors who have served an exchanger in their professional capacities within the prior two years are also disqualified from serving as a Qualified Intermediary for a taxpayer in an exchange. It is essential, therefore, that an exchanger 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, (iii) is the company or its owners, or both, members of local and national boards and committees dealing with real estate and 1031 exchanges, and (iv) does the company have the technical expertise to facilitate the exchange.

1.  How Long Has the Company Been in Business?

            The increased popularity and volume of 1031 exchanges, especially on the east coast, has inspired a concurrent growth in the number of qualified intermediaries created to handle these exchanges. Many of the new qualified intermediaries were opened by business people who figured it would be a good industry to become involved with to make a profit. Unfortunately, most of these novice business ventures failed as exchangers and their advisors quickly recognized that the newer qualified intermediaries lacked the experience to effectively handle their exchanges. New companies keep popping up, however, so an exchanger should determine whether the intermediary they are considering has a long history of facilitating exchanges.      

2.  Who are the Owners and How Long have they Owned the Intermediary?             

            The exchanger should ask who owns the qualified intermediary and for how long. A trend towards consolidation in the 1031 industry has created a problem. Well established qualified intermediaries with excellent reputations have been bought by individuals with no prior experience in the exchange industry. Some of these new owners operated their new businesses recklessly and even criminally. 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 owners.

            Two well known qualified intermediaries were forced to shut their doors recently. In one case, an example of reckless behavior, the new owner used the exchange funds to speculate in real estate, expecting to use funds from new exchanges to cover the older exchanges. A downturn in the market caused the wheel to stop, forcing the intermediary into bankruptcy.  In the other case, an example of criminal behavior, the new owner used the funds to fund his lavish lifestyle, with no apparent plan or expectation to replenish the funds. The losses in the latter case are expected to be in the tens of millions.

            The lesson to be learned from the foregoing is that the exchanger must determine the identity of the current owners, and then review the credentials and reputation of the current owners.

3.  Is the company or its owners, or both, members of local and national boards and committees dealing with real estate and 1031 exchanges?

            Participation in local and national boards, committees and trade organizations can indicate an intermediary's commitment to the 1031 industry. For instance, the Federation of Exchange Accommodators ("FEA") is the national trade association organized to represent professionals who conduct like-kind exchanges under Internal Revenue Code §1031. The FEA promotes ethical standards for the industry and provides input on pending State and Federal legislation, IRS and Treasury rulings and regulations, and court decisions. Most reputable qualified intermediaries belong to the FEA.

4. Does the Intermediary have the Technical Expertise to Facilitate the Exchange?

The owners and employees of the qualified intermediary should have a thorough understanding of all aspects of 1031 exchanges. Improper documentation or inattention to strict time deadlines has invalidated many attempted exchanges. The exchanger should look for a qualified intermediary that is owned and operated by tax professionals, preferably tax attorneys who concentrate in real estate taxation. The exchanger should also look to see if any of the owners or employees have earned the designation of Certified Exchange Specialist® (CES), a designation bestowed by the FEA upon those professional individuals who meet specific work-experience criteria and pass an exam on exchange laws and procedures.

The IRS is constantly issuing guidance in this area, and the exchanger should find a qualified intermediary that keeps abreast of these changes, as indicated by published articles, newsletters, or seminars presented by its principals.