Choose a SAFE, SECURE and RELIABLE Qualified Intermediary
1031 Exchange Qualified Intermediaries (often referred to in the real estate industry as 1031 Exchange Accommodators or 1031 Exchange Facilitators) are a crucial part of any successful 1031 Exchange transaction. You should therefore exercise significant care when evaluating and selecting your Qualified Intermediary because of the critical role the company will play in the administration of your 1031 Exchange transaction. (See article entitled "Qualified Intermediaries Are Not Created Equal.")
The purpose of this article is to assist you, as a potential Exchangor, in developing an understanding of the due diligence issues that should be evaluated in selecting your 1031 Exchange Qualified Intermediary. The due diligence process should never be taken lightly. The one thing that we have learned over time is that it does not matter how large or small the Qualified Intermediary is, but how well the "QI" is managed.
Role of the 1031 Exchange Qualified Intermediary
The 1031 Exchange Qualified Intermediary is authorized under Section 1.1031 of the Department of the Treasury Regulations and is essentially responsible for: (1) preparing the 1031 Exchange agreements and related transaction documents in order to properly structure your 1031 Exchange transaction; (2) receiving, holding and safeguarding your 1031 Exchange funds throughout your 1031 Exchange transaction; and (3) advising or consulting with you and your advisors regarding the implementation of your 1031 Exchange transaction to ensure compliance with applicable Internal Revenue Codes, Treasury Regulations and related Revenue Rulings and Procedures.
Qualified Intermediaries Are Not Licensed, Regulated or Audited
It is extremely important to note that 1031 Exchange Qualified Intermediaries are generally not licensed, regulated, audited or otherwise monitored by any governmental regulatory body. We made the decision to launch Exeter Trust Company so that we would be licensed, regulated and audited. It was the right thing to do in order to better protect our clients. Exeter Trust Company is licensed, regulated and audited by the Wyoming Division of Banking.
In addition, 1031 Exchange Qualified Intermediaries are generally not required to be bonded, insured or maintain any other form of minimum equity capitalization. Exeter Trust Company is bonded, insured and is required to maintain significant equity capital since we are licensed by the Wyoming Division of Banking.
It is extremely important for you to know how to properly evaluate and choose a SAFE and SECURE 1031 Exchange Qualified Intermediary for your 1031 Exchange transaction.
You should always perform a careful and thorough due diligence review before making your final selection. You should never pick your 1031 Exchange Qualified Intermediary based solely on their 1031 Exchange fees, costs and charges or the size of the institution. Choosing the wrong 1031 Exchange Qualified Intermediary to administer your 1031 Exchange could be a very expensive mistake due to the Qualified Intermediary's critical fiduciary responsibilities and obligations through out your 1031 Exchange transaction.
Due Diligence Process for Evaluating Qualified Intermediaries
There is very little written or published guidance or reference material available regarding the safe and successful administrative practices for 1031 Exchanges and/or protecting and safeguarding your 1031 Exchange funds and assets.
You may focus all too often on issues such as size of the Qualified Intermediary, 1031 Exchange fees, interest rates paid, turn around times, branch office locations, and the like, when interviewing potential 1031 Exchange Qualified Intermediaries. While many of these issues are important considerations and should not be ignored or overlooked, there are other more crucial criteria that you must question and evaluate first.
Identifying and Evaluating Critical Risks
The critical issues that you must review and evaluate prior to making your final decision on which 1031 Exchange Qualified Intermediary to retain includes, but is not limited to, the following areas:
- Is the Qualified Intermediary subject to any kind of government oversight, such as being licensed, regulated and audited by a regulatory body like a State Division of Banking (DOB or DFI), Office of the Comptroller of the Currency (OCC), or Federal Deposit Insurance Corporation (FDIC), or Federal Reserve (FRB)?
- Are the actual 1031 Exchange accounts subject to governmental regulation and oversight?
- Does the Qualified Intermediary have the technical capability to successfully administer your 1031 Exchange transaction?
- Has the Qualified Intermediary implemented internal processes and audit controls to safeguard your 1031 Exchange funds?
- Is each individual 1031 Exchange account set-up with its own separate, segregated Qualified Trust Account or Qualified Escrow Account?
- What are the decision criteria and guidelines used by the Qualified Intermediary for the investment of your 1031 Exchange funds
- Protection from potential errors or omissions by the Qualified Intermediary
- Protection from potential theft or embezzlement of 1031 Exchange funds
An experienced and professional 1031 Exchange Qualified Intermediary will understand these concerns and should be happy to discuss these crucial issues with you. And, well managed institutional 1031 Exchange Qualified Intermediaries like Exeter 1031 Exchange Services, LLC will have already evaluated the applicable risks, addressed the critical issues and implemented appropriate safeguards to protect your 1031 Exchange funds to ensure the successful completion of your 1031 Exchange transaction.
The following comments will provide specific and acceptable industry guidelines and standards that will be helpful in evaluating 1031 Exchange Qualified Intermediaries and in determining if acceptable and adequate controls and safeguards are being practiced. You should never take short-cuts when evaluating and selecting a 1031 Exchange Qualified Intermediary for your 1031 Exchange transaction; to do so could have disastrous consequences.
1031 Exchange Technical Capability — Knowledge, Expertise, and Experience
The most frequent problem encountered in the 1031 Exchange industry is that many Qualified Intermediaries do not have the technical depth, experience and expertise necessary to review the transaction documents and catch problems before the transaction closes. Many 1031 Exchange Qualified Intermediaries know how to process 1031 Exchange transactions but often do not know what to look for when reviewing your transactional documents, or will not review them out of concern for their own liability. Either way, it is a huge disservice to you.
Therefore, the most important issue to evaluate is the technical ability, expertise and experience of the Qualified Intermediary’s 1031 Exchange advisors because of the highly technical nature of 1031 Exchange transactions. The slightest mistake could result in a disallowed 1031 Exchange and the recognition of significant capital gain and depreciation recapture income tax liability.
You should ensure that the employees of the 1031 Exchange Qualified Intermediary have sufficient technical depth, knowledge, experience and expertise to assist with structuring your 1031 Exchange, reviewing your transaction documents for potential problems, and in the drafting of your 1031 Exchange agreements.
An experienced 1031 Exchange Qualified Intermediary like Exeter 1031 Exchange Services, LLC can easily identify potential problems with a 1031 Exchange and recommend solutions to correct the issue before it is too late. Most technical problems in the administration of a 1031 Exchange can not be corrected after the transaction has closed, so it is vital that problems are identified and resolved before the transaction closes.
You should interview prospective 1031 Exchange advisors. Do not be shy or timid; ask lots of questions and compare the answers and technical depth of experience in order to separate the true 1031 Exchange experts from the rest. This is a crucial step in selecting the right 1031 Exchange Qualified Intermediary to administer your 1031 Exchange transaction and will go a long way to ensure that you end up with a successful 1031 Exchange transaction.
Policies, Procedures and Internal Audit Controls
Sophisticated policies, procedures and internal audit controls are critical in minimizing the risk of loss to your 1031 Exchange funds and assets while being held, managed and safeguarded by your Qualified Intermediary. Internal controls monitor and safeguard 1031 Exchange funds during the administration of your 1031 Exchange transaction.
Many 1031 Exchange Qualified Intermediaries jump right to internal audit controls when evaluating, planning and implementing new internal control processes to protect its clients' assets. However, good internal processes and controls should always begin with the careful recruitment and retention of trusted employees that will always put the clients' needs and interests first, including the safeguarding of clients' 1031 Exchange assets. The recruitment of trusted employees should always start with a complete and in depth background check to include searches of Federal, state, county and city records for criminal convictions, civil litigation, civil liens or judgments, credit or collection problems, and more. Prospective employees should also be screened for illegal substance abuse issues. Exeter 1031 Exchange Services, LLC has always used these internal recruiting processes because they eliminate many of the potential problems before they even start.
In addition, members of the Federation of Exchange Accommodators ("FEA") — such as Exeter 1031 Exchange Services, LLC — are also required to have any and all employees that control, manage or otherwise handle or have access to clients' assets be fingerprinted. The FEA also performs another criminal background check when the fingerprint cards are submitted to the Department of Justice for processing.
Institutional 1031 Exchange Qualified Intermediaries will have implemented sophisticated internal audit controls to ensure the safety of your 1031 Exchange funds. These internal processes and audit controls typically include multiple checks and balances, including, but not limited to, multiple parties required to initiate any disbursement of funds, multiple parties to access, process and print checks, multiple parties required to access, process and send wire transfers, daily balancing and reconcilement of all fiduciary bank accounts with multiple party review and approval requirements, segregation of 1031 Exchange administration processes from operational functions such as cash management and balancing, calling you prior to any disbursement of your 1031 Exchange funds, and more.
Separate, Segregated Qualified Trust Accounts
1031 Exchange funds should always be deposited and held in separate, segregated Qualified Trust Accounts or Qualified Escrow Accounts in order to protect clients' 1031 Exchange funds from an unexpected voluntary or involuntary bankruptcy filing by the Qualified Intermediary. Qualified Escrow Accounts serve the same purpose as a Qualified Trust Account, although recent court decisions have leaned more favorably toward the use of the Qualified Trust Account structure.
Exeter 1031 Exchange Services, LLC has always deposited and held clients' 1031 Exchange proceeds in a separate, segregated Qualified Trust Account in order to protect its clients' 1031 Exchange assets.
Investment of Your 1031 Exchange Funds
1031 Exchange Qualified Intermediaries' fiduciary responsibilities include the prudent safeguarding, management and investment of clients' 1031 Exchange funds. You should take great care in selecting a Qualified Intermediary that takes its fiduciary responsibilities and its duty of care for its clients extremely seriously when it comes to receiving, holding, safeguarding and investing your 1031 Exchange funds.
The 1031 Exchange Qualified Intermediary should have adopted an investment policy that requires safe, secure and prudent investments, that the funds can be withdrawn upon short notice for use in the acquisition of your like-kind replacement properties and that the funds earn a competitive interest rate. The investment policy should place more emphasis on the safety and liquidity of your 1031 Exchange funds than with the interest rate earned on your funds.
The 1031 Exchange Qualified Intermediary should be happy to provide you with more detailed information regarding the specific investment vehicles, strategies and financial institutions used by them for your 1031 Exchange funds.
Safety of 1031 Exchange Funds
Another important element that is arguably just as critical as the 1031 Exchange Qualified Intermediary’s investment policy is the protection of your 1031 Exchange funds while being held, managed, safeguarded and invested by the 1031 Exchange Qualified Intermediary.
1031 Exchange Qualified Intermediaries hold significant amounts of 1031 Exchange funds on behalf of many, many clients with no regulatory oversight, no insurance, and no bonding requirements. 1031 Exchange Qualified Intermediaries have tremendous fiduciary responsibilities and obligations to hold and safeguard your 1031 Exchange funds, and yet have no governmental regulatory oversight or minimum financial requirements what-so-ever. Most clients never ask how their 1031 Exchange funds will be protected or if they are insured. Do not be penny wise and pound foolish. Investigate the methods and structures used to protect your 1031 Exchange funds. Asking the right questions could save you from a catastrophic loss.
You must ensure that the 1031 Exchange Qualified Intermediary you select to administer your 1031 Exchange takes its fiduciary duty of care very seriously by obtaining and maintaining the necessary and appropriate levels of bonding and insurance coverage as well as equity capitalization to cover potential losses sustained by you due to administrative mistakes, errors or omissions by the 1031 Exchange Qualified Intermediary.
Errors and Omissions in the Administration of a 1031 Exchange
Although sophisticated internal controls, safeguards, processes and excellent recruiting and training procedures by the 1031 Exchange Qualified Intermediary can minimize the risk of loss, 1031 Exchange officers and administrators are still only human and will occasionally make mistakes in the administration of client’s 1031 Exchange transactions (errors and/or omissions).
The 1031 Exchange is a highly technical process and mistakes will occasionally occur that could result in a disallowed 1031 Exchange transaction and the subsequent recognition of your depreciation recapture and capital gain income tax liabilities. To protect yourself from this risk, you should always ensure that the 1031 Exchange Qualified Intermediary has purchased and maintains sufficient amounts in Errors and Omissions (E&O) insurance coverage to insure against the risk of loss resulting from human error.
Errors and Omissions insurance is perhaps the most important insurance coverage for a 1031 Exchange Qualified Intermediary to maintain — even more important than Fidelity Bond coverage — because human error is more likely to occur than theft or embezzlement of funds.
Errors & Omissions (E&O) insurance coverage for 1031 Exchange Qualified Intermediaries is extremely difficult to qualify for and obtain — especially in the 1031 Exchange industry. E&O insurance coverage is also extremely expensive. Many 1031 Exchange Qualified Intermediaries do not maintain Errors and Omissions insurance coverage for these reasons.
This should be a major concern for you for the simple reason that human error is a much more likely occurrence than theft or embezzlement of funds, and is more difficult to protect against with internal controls and processes. Errors and Omissions insurance is the coverage you are more likely to need. While conducting your due diligence, you should make sure that the 1031 Exchange Qualified Intermediary does in fact maintain sufficient Errors and Omissions Insurance coverage.
To ascertain whether the 1031 Exchange Qualified Intermediary does maintain sufficient Errors and Omissions insurance coverage, you should request a copy of the insurance binder in order to verify the insurance underwriter, the policy limit, and policy term/expiration date. Ask for the insurance agent’s contact information and always verify that the Errors and Omissions insurance coverage does in fact exist and is still in full force and effect and that the information contained on the insurance binder is accurate, complete and up-to-date.
Theft, Embezzlement or Misappropriation of 1031 Exchange Funds
1031 Exchange Qualified Intermediaries administer thousands of 1031 Exchange transactions and receive, hold and safeguard millions of dollars in 1031 Exchange funds each and every year, so it is critical that appropriate safeguards are put into practice and adequate levels of insurance and bonding are maintained in order to protect your 1031 Exchange funds.
Institutional 1031 Exchange Qualified Intermediaries should have designed and implemented sophisticated internal controls, independent audit programs and checks and balances to prevent theft or embezzlement of your 1031 Exchange funds, including extensive pre-employment background checks and substance abuse testing.
However, despite these extensive controls, institutional 1031 Exchange Qualified Intermediaries know that it is not only prudent but critical to maintain sufficient Fidelity bond coverage to insure against potential and unanticipated theft, embezzlement or misappropriation of your 1031 Exchange funds by an employee of the firm. Fidelity bond coverage insures the 1031 Exchange Qualified Intermediary against this risk of loss.
You should always inquire about the Fidelity bond insurance coverage maintained by the 1031 Exchange Qualified Intermediary to ensure that the insurance coverage does in fact exist and that it is still in full force and effect (has not been cancelled or expired) and that the insurance coverage or policy limit is sufficient for the size and scope of the 1031 Exchange operation.
To ascertain whether the 1031 Exchange Qualified Intermediary does maintain sufficient Fidelity Bond insurance coverage, you should request a copy of the insurance binder to verify the insurance underwriter, the policy limit, and policy term/expiration date. Ask for the insurance agent’s contact information and verify that the Fidelity bond insurance information contained on the insurance binder is accurate, complete and up-to-date.
Ask whether the Fidelity bond is “per occurrence” or merely “in aggregate”. The term “in aggregate” means the policy limit is the total or maximum coverage available to Investors for the 12 month policy period regardless of the number of losses (thefts) during the year, and may not be sufficient coverage if the 1031 Exchange Qualified Intermediary experiences significant losses during the 12 month policy period. The term “per occurrence” means the policy limit applies to each individual theft or loss and provides better protection for you. The difference in the actual amount of coverage provided between “per occurrence” and “in aggregate” can be staggering.
Incidents of theft are quite rare among institutional 1031 Exchange Qualified Intermediaries. Human error is a more realistic risk to your 1031 Exchange transaction. However, it is important to ensure that the 1031 Exchange Qualified Intermediary has taken steps to protect you from each of these risks.
Exeter 1031 Exchange Services, LLC would be happy to discuss these specific issues with you and answer any questions that you might have.
Suggested Due Diligence Questions
Exeter 1031 Exchange Services, LLC has put together some suggested due diligence questions that you should ask prospective 1031 Exchange Qualified Intermediaries. While there are numerous other issues that should be considered, Exeter 1031 Exchange Services, LLC feels these are the most important issues/questions that should be on the top of your due diligence list.
- Are you subject to any kind of government oversight or regulation?
- What regulatory body or governmental agency are you licensed, regulated and audited by?
- Do you hold clients' 1031 Exchange funds in a separate, segregated Qualified Trust Accounts or a Qualified Escrow Accounts?
- Do you maintain fidelity bond insurance coverage to insure against employee theft, embezzlement or misappropriation of the 1031 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?
- Do you maintain sufficient errors and omissions (E&O) insurance coverage to insure against any 1031 Exchange Qualified Intermediary error or omission?
- What is the policy limit of your errors and omissions insurance coverage?
- Do your fidelity bond and errors and omissions (E&O) insurance policies cover just the 1031 Exchange 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 such as title insurance, escrow, etc.?
- What type of internal processes and internal audit controls have you implemented to protect my 1031 Exchange assets?
- Do your 1031 Exchange administrators call me prior to the disbursement of my 1031 Exchange funds to ensure that I want the funds disbursed (as opposed to disbursing when escrow calls).
- Where are my 1031 Exchange funds held or invested?
- What type of specific investments do you use for my 1031 Exchange funds?
- How many years have you been administering 1031 Exchange transactions?
- How many 1031 Exchanges have you administered (individual 1031 Exchange officer and 1031 Exchange Qualified Intermediary)?
State of Washington Required Disclosures
"Washington state law, RCW 19.310.040, requires an exchange facilitator to either maintain a fidelity bond in an amount of not less than one million dollars that protects clients against losses caused by criminal acts of the exchange facilitator, or hold all client funds in a qualified escrow account or qualified trust."
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