Preserving equity through the deferral of taxes is the primary motivation for entering into a 1031 exchange. Failure to ask a few crucial questions regarding the exchange funds, however, can result in a devastating loss of a taxpayer’s entire investment.
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 makes most taxpayers queasy. The preferred solution is to have the funds deposited into a dual-signature account that requires the signatures of both the taxpayer and the qualified intermediary to transfer 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.
2. Are my funds in a separate 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, not assets of the taxpayers, and the funds were ultimately used to pay the general creditors of the intermediary.
A taxpayer should insist that exchange funds be held in a separately identifiable account, segregated from all other client accounts and separate from the qualified intermediary’s account. 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?
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 funds with either large, national banks such as Bank of America, Citizens Bank and Wachovia or strong regional banks in the area where the taxpayer is exchanging.
The exchange funds should be invested in highly liquid cash accounts. A 1031 exchange provides many taxpayers with the ability to close a transaction quickly, and the funds need to be readily available. Furthermore, a qualified intermediary should never invest the funds in any vehicle exposed to market risks.
4. What is the intermediary’s reputation?
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 that taxpayers do their homework and ask: How long has the company been in business? Who are the owners, and how long have they owned the company? 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.
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.
5. Is the qualified intermediary bonded and insured?
The intermediary should have a fidelity bond to protect against theft or embezzlement and an errors and omissions policy to insure against losses resulting from an employee’s negligence.
In conclusion, the taxpayer should 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.
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.
Thomas J. Moylan is co-owner of All States 1031 Exchange Facilitator, with offices in Boston and Providence. A lawyer and veteran of the 1031 industry, he writes regularly about 1031 issues.
