“Be careful! I lost my entire life savings in a 1031 exchange. … Numerous people who had worked their entire lives building equity in a property had everything stolen from them. 1031 exchanges are not regulated by the feds and are only as trustworthy as the people managing them! Be careful!” Sam commented on an Atlas 1031 article on LandThink. He understands the tragedy of working with unprofessional 1031 exchange managers, also known as Qualified Intermediaries. Property owners who wish to take advantage of tax deferred exchanges without a risk of losing their equity should be aware of three ways of how to distinguish between a trustworthy and an unreliable Qualified Intermediary.
Why 1031 Exchange?
When selling real and personal property held for investment or use in a business, your CPA, Realtor, Estate Attorney may suggest a 1031 tax deferred exchange to defer federal and state capital gains and recaptured depreciation taxes. These taxes can represent upwards of 40% of the sales price. A 1031 exchange uses those otherwise paid tax dollars towards purchasing replacement property, providing an interest free loan. Foreign nonresidents can also use 1031 exchanges and are subject to the Foreign Investment Real Property Tax Act of 1980 (FIRPTA).
What does a Qualified Intermediary Do?
A 1031 exchange requires a Qualified Intermediary (QI) who creates exchange documents in accordance with Internal Revenue Service Code 1.1031 and holds the net equity from the sale in an escrow account until needed to acquire the replacement property. Until the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the QI industry was not regulated. Eight states (Washington, Oregon, California, Idaho, Nevada, Colorado, Virginia and Maine) have enacted their own requirements to protect their constituents from QIs who may have questionable intent. Some of those requirements include the use of Qualified Escrow Accounts or a $1,000,000 fidelity bond and a minimum $250,000 errors and omission insurance policy or face civil or criminal penalties.
QI Sin Number One
Holding the exchange proceeds in illiquid commingled accounts.
Vs.
Holding the proceeds in segregated, liquid accounts.
By holding the exchange funds in commingled accounts, the QI may be attempting to pool the funds to achieve higher yields. QIs generate revenue by a fee and interest earned on the escrow account. Be sure the funds are liquid and in a segregated escrow account. You want to be able to reach out at anytime and request funds for an earnest money deposit or quick closing. The taxpayer can request the exchange funds be held in alternative investments, but the funds must be liquid and immediately available.
QI Sin Number Two
Using out of date exchange documents.
Vs.
Current exchange documents.
The 1031 regulations are affected by case law from the Supreme Court, Court of Appeals, trial courts, the Tax Court, the district court, and the Court of Federal Claims, regulations prescribed by the Commissioner of the Internal Revenue Service (IRS), revenue procedures, revenue rulings, private letter rulings (PLRs), Technical Advice Memorandums (TAMs), Field Service Advice (FSA) and Field Attorney Advice (FAA). Unassuming and uninformed QIs who advise or use out of date exchange documents are not protecting your interests.
QI Sin Number Three
Escrow accounts are all alike.
Vs.
Use a Qualified Escrow Account or a PIN for security.
Qualified escrow accounts (QEA) require dual signatures to disburse funds representing optimum QI protection. One of those signatures must match the notarized signature of the taxpayer on file. The second signature can be from the QI who the bank knows. As an alternative, a personal identification number is created known only between the taxpayer and the bank. The taxpayer is contacted by the bank after the wire out request is initiated by the QI authorizing the wire out.
How to find a reliable Qualified Intermediary?
Additional suggestions include working with a Certified Exchange Specialist® who pledges to act in accordance to a strict Code of Ethics governed by the Federation of Exchange Accommodators (FEA). The principal QI member that is responsible for moving the exchange funds undergoes an annual criminal background check. If a QI is acquired, the new principal is also subject to a criminal background check.
Trust but verify.
What are your suggestions to safeguard exchange funds?
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