"What is in a Name?" (with apologies to Shakespeare): Protect your Assets by Scrutinizing the Qualifications of your "Qualified Intermediary"
The question is: What makes a "qualified intermediary" qualified? Answering that question is the first order of business when entering into a "1031 Exchange."
Popularity of the so-called "1031 Exchange" has increased in recent years, and the number of 1031 exchange companies - or "qualified intermediaries" - has also increased. IRS Regulations allow a taxpayer to conduct a 1031 exchange by using a qualified intermediary to facilitate the tax-deferred exchange. In many cases, a qualified intermediary, rather than the seller-taxpayer, takes possession of the proceeds of the sale of property because the tax-deferred status of the exchange is deemed to have ended as soon as the taxpayer has actual or constructive receipt of the funds.
Despite the proliferation of 1031 exchange companies, few federal regulations govern "qualified intermediaries" and their operations. Almost anyone can form a 1031 exchange company and begin facilitating 1031 exchanges as a qualified intermediary. IRS Regulations define a "qualified intermediary" as a person who "is not the taxpayer or a disqualified person" who "enters into a written agreement with the taxpayer (the "exchange agreement"). . . ." Treas. Reg. § 1.1031(k)-1(g)(4)(iii). Interestingly, individual states have taken a more active role than the federal government in regulating qualified intermediaries and their practices.
Effective as of October 2, 2008, California law requires that any qualified intermediary doing business in the State of California must, among other things: (i) maintain minimum fidelity bond coverage of $1,000,000 (or deposit cash, securities or a letter of credit in such amount); (ii) maintain E&O insurance coverage of at least $250,000; (iii) not commingle exchange funds with operating funds; and (iv) satisfy investment goals of liquidity and preservation of principal in investing exchange funds.
In addition to having similar requirements for E&O coverage and bonding, authorities in Nevada are obligated to audit qualified intermediaries at least once every five years, and any purchaser of a qualified intermediary business must submit to a background check.
Given the crucial role that qualified intermediaries play in tax-deferred exchanges, parties should closely scrutinize potential qualified intermediaries as part of their due diligence (in addition to relying on any statutory restrictions that may be applicable), particularly in light of the recent bankruptcy filing by Land America's 1031 exchange subsidiary. At a minimum, a party should examine the technical capability of the qualified intermediary, the internal processes used by the company to safeguard assets, the company's criteria for determining how assets will be invested, and the safeguards used by the company to protect assets against errors, omissions, theft, and embezzlement. A party can also request that its funds be held in a separate account rather than commingled with other exchange funds. A professional qualified intermediary entity will understand these concerns and should not be reluctant to discuss these issues freely, so do not hesitate to raise these questions (and others) early and often.