Taxpayers often contact prospective Qualified Intermediaries and ask them about fees, 1031 exchange transactional requirements and structures, tax implications, location of the Qualified Intermediary, etc. While these issues are important, the Taxpayer rarely inquires into the Qualified Intermediary’s financial strength, bonding, and methods used to safeguard the Taxpayer’s 1031 exchange funds. The safety of the funds should be the most important part of the Taxpayer’s due diligence process. This article will assist the Taxpayer in identifying the potential risks associated with a Qualified Intermediary and what questions to ask and issues to review in order to protect his or her 1031 exchange funds. There are three primary risks that the Taxpayer should be cognizant of when researching, evaluating and selecting his or her Qualified Intermediary. The three risks are:
- Theft or embezzlement of 1031 exchange funds
- Errors or omissions in the administration of a 1031 exchange
- Involuntary or voluntary Bankruptcy of the Qualified Intermediary
Experienced Qualified Intermediaries like Diversified Exchange Corporation will understand your concerns. They will have analyzed and addressed these concerns and will have already implemented appropriate safeguards to protect your 1031 exchange funds. The following comments will help you determine if acceptable safeguards have been put into place.
Theft or Embezzlement of 1031 Exchange Funds Institutional Qualified Intermediaries like Diversified Exchange Corporation plan and implement very sophisticated internal control systems, audit procedures and checks and balances to prevent misappropriation of client 1031 exchange funds. However, professional Qualified Intermediaries also know that it is important and prudent to maintain sufficient Fidelity Bond coverage to insure against a potential theft or embezzlement of client 1031 exchange funds. Qualified Intermediaries administer thousands of 1031 exchange transactions and millions of dollars in 1031 exchange funds each year, so the Fidelity Bond policy limit should be an important consideration. When conducting his or her due diligence, the Taxpayer should verify that the Qualified Intermediary does maintain sufficient Fidelity Bond coverage, and should request a copy of the insurance binder and the insurance agent’s contact information in order to verify that the Fidelity Bond coverage is still in full force and effect and to verify the policy limits. It is also important for the Taxpayer to ask whether the Fidelity Bond coverage is “per occurrence” or merely “in aggregate”. The difference in the actual amount of coverage provided between these can be surprising. “In aggregate” means the policy limit is an annual coverage amount and limited to the annual policy limit regardless of the number of thefts during the year, while the “per occurrence” coverage means that each theft is covered up to the policy limit.
Errors and Omissions in the Administration of a 1031 Exchange Even with superior quality control processes, 1031 exchange administrators are human and may occasionally make mistakes. It is important to ensure the Qualified Intermediary has obtained Errors and Omissions (E&O) insurance coverage to insure against losses resulting from an employee’s error or omission. Errors & Omissions (E&O) insurance coverage is very difficult to qualify for – especially in the 1031 exchange industry – and is very expensive to obtain. It is for these reasons that many Qualified Intermediaries do not have Errors and Omissions insurance coverage. This coverage is perhaps even more important that other insurance coverage provided because human error is more likely than theft or embezzlement of funds. As previously mentioned with the Fidelity Bond coverage, the Taxpayer should verify that the Qualified Intermediary does maintain sufficient Errors and Omissions Insurance coverage when conducting his or her due diligence, and should request a copy of the insurance binder and the insurance agent’s contact information in order to verify that the Errors and Omissions Insurance coverage is still in full force and effect as well as to verify the policy limits.
Bankruptcy of the Qualified Intermediary Bankruptcy is a rare event within the 1031 exchange industry, but it is possible and is an important risk that must be considered and addressed. The bankruptcy could be voluntary or involuntary. Bankruptcy is often thought of in terms of financial and/or credit problems related to some form of theft or embezzlement of funds. However, bankruptcy can also result from a catastrophic event such as an earthquake, fire, flood, hurricane, tornado, or act of terrorism, which may financially devastate the Qualified Intermediary and force it into involuntary bankruptcy. The 9/11 terrorism attacks against the United States of America is a perfect example. This attack forced a lot of really good companies into involuntary bankruptcy. We also know that large companies are not immune to financial collapse as demonstrated by the Enron case. The Taxpayer must ensure that his or her 1031 exchange funds are held by the Qualified Intermediary in such a manner that will protect his or her 1031 exchange funds from a bankruptcy filing, including the attachment of the 1031 exchange funds by creditors of the Qualified Intermediary. 1031 exchange funds held by a Qualified Intermediary under its corporate name will typically be determined to be corporate funds by the bankruptcy court and included as part of the bankruptcy estate and be subject to creditor claims. The Department of the Treasury Regulations provide for Qualified Escrow Accounts or Qualified Trust Accounts. The Qualified Intermediary never actually receives or holds the Taxpayer’s 1031 exchange funds, but has the 1031 exchange funds transferred directly into the Qualified Escrow Account or Qualified Trust Account held by the escrow agent or trustee of the account for the benefit of the Taxpayer. 1031 exchange funds held by either of these vehicles are considered fiduciary funds and not subject to the bankruptcy estate or creditor claims. The Qualified Escrow Account of the Qualified Trust Account must meet specific criteria outlined by the Department of the Treasury. The 1031 exchange funds cannot be held by the Taxpayer or by a disqualified person. The Agreement must expressly limit the Taxpayer’s right to receive, pledge, borrow, or otherwise obtain the benefits of the 1031 exchange funds until after the Department of the Treasury Regulations so permit.
Suggested Due Diligence Questions Here are some suggested questions that you should ask prospective Qualified Intermediaries:
- Do you (Qualified Intermediary) maintain sufficient fidelity bond coverage to insure against employee theft or embezzlement of the exchange funds?
- What is the policy limit of your fidelity bond coverage?
- Is your fidelity bond coverage “per occurrence” or merely “in aggregate”?
- Will you provide me with copies of your insurance binders and the contact information for your insurance agents so I can verify that your insurance coverage is still in full force and effect?
- What is the policy limit of your errors and omissions insurance coverage?
- Do you maintain sufficient errors and omissions (E&O) insurance coverage to insure against errors or omissions that creates a loss for me?
- Do your fidelity bond and errors and omissions (E&O) insurance policies cover just the Qualified Intermediary or do they also cover numerous other related entity operations that might diminish the overall protection to me in the event of multiple losses throughout the consolidated entity?
- Are all exchange funds held in separate, segregated qualified escrow or qualified trust accounts to ensure that my 1031 exchange funds can not be attached by the Qualified Intermediary's creditors in the event of a voluntary or involuntary bankruptcy filing?
- Does the Qualified Intermediary's family of companies include regulated companies such as title insurance companies, banking organizations or trust companies, which provide regulatory oversight of the corresponding operations?
- Is the Qualified Intermediary part of a family of companies with significant financial strength and equity capital?
- What type of sophisticated internal controls, audit procedures and checks and balances have you [Qualified Intermediary] implemented to protect my 1031 exchange funds?
- Is the Qualified Intermediary audited by an independent auditor and/or an internal audit group?
- Are there any risk management or operational audits performed by outside auditors and/or internal audit groups?
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