For Maryland attorneys whose clients invest in properties, safety of funds is a fundamental concern of a 1031 Exchange strategy. Safety of funds is the most important question to pose to a Qualified Intermediary (QI) before beginning a 1031 Exchange.
Because safe-harbor rules prohibit investment property owners from possessing, accessing or benefiting from funds generated from the sale of relinquished property in 1031 Exchanges, a QI must hold the sale proceeds. Additionally, investment property owners are prohibited from using their own attorney, CPA, Certified Financial Planner, broker/dealer, real estate professional or any “related party” as a QI.
However, the QI industry is virtually unregulated in most states. Thus, in the past decade, disreputable people entered the QI industry, resulting in mismanagement, malfeasance and a handful of high-profile bankruptcies. Investment property owners whose QI failed in the midst of an Exchange faced losing their sale proceeds and being held liable for taxes on the gain from the sale of the relinquished property.
The recent bankruptcy of Denver-based 1031 Group (see The 1031 Tax Group, LLC, et al., 07-11448 U.S. Bankruptcy Court, Southern District of New York) clearly shows the importance of security in the handling of client’s funds in a 1031 Exchange.
There are a several methods used by QIs to secure investors’ funds, each with advantages and drawbacks.
- Segregated Accounts. Instead of co-mingling Exchange funds, some QIs “segregate” client funds in separate bank accounts. But segregated accounts offer no protection from QI bankruptcy. If the QI fails, each deposit holder in the midst of a 1031 Exchange with that QI is classified as an “unsecured creditor.” That is the very bottom rung of priority on the ladder of payouts from the bankruptcy trustee. In those cases, unsecured creditors typically receive pennies on the dollar of lost sale proceeds but are still liable to the IRS for all taxes.
- FDIC Insurance. Some QIs tout FDIC as protection. FDIC provides $100,000 of insurance coverage, but only per depositor. Since most QIs title accounts in their own name to meet federal rules restricting investment property owners from having access to Exchange funds, in cases of malfeasance or bankruptcy, the $100,000 insurance provided by FDIC is shared equally by all for whom the QI is holding Exchange funds at the time that the QI failed to perform. Moreover, while FDIC raised insurance limits in April 2006, the new cap applies only to certain types of accounts such as Roth IRAs and self-directed Keoghs; not 1031 Exchange funds. Lastly, there is no guarantee that a QI actually deposits funds from its 1031 Exchanges in a bank.
- Too Big to Fail? The next level of protection for the 1031 Exchange investment property owner is a large QI unlikely to file for bankruptcy. Unfortunately, recent failures of mega-companies such as Worldcom and Enron have shaken the public’s confidence in such giant enterprises.
- Strong Current or Quick Ratios. More important than the sheer size of the QI is its liquidity, which should be compared to its current liabilities to determine the company’s Current or Quick Ratio.This will denote if it can weather at least six months of expenses before running out of cash. Since 1031 Exchanges must be completed within 180 days, this is reliable evidence that Exchange funds are fairly safe.
- Bonding and Insurance. The ultimate protection for 1031 Exchange proceeds is to use a QI that is “bonded and insured.” In assessing the bonding and insurance limits of a QI, consider the amount of the bond or insurance and whether coverage limits are “aggregate” or “per occurrence.” Aggregate bonding or insurance refers to the total amount of coverage for which the QI is covered by the policy.
- The Gold Standard. The best QI coverage is a large “per occurrence” policy, which bonds each client’s 1031 Exchange up to the amount identified in the policy. For example, a $1,000,000 per occurrence policy means the QI has $1,000,000 of protection from loss for each Exchange client.
For optimum security of funds, Maryland attorneys should advise investment property Exchangers to insist that their 1031 Exchange funds be bonded and insured by the QI under a substantial per occurrence policy exceeding the amount of the 1031 Exchange proceeds. The QI should have sizeable assets (preferably in the billions of dollars) and liquidity as evidenced by a strong current or quick ratio. Anything less constitutes an unnecessary risk not only with the hard-earned investment property equity but also the capital gains and state taxes and depreciation recapture deferred in the 1031 Exchange.
Walter Hoffman is the Maryland and Washington D.C.-based Business Development Consultant of National Accounts for Bayview 1031, a subsidiary of Bayview Financial L.P., a financial and real estate services company. Stephen A. Wayner, Esq., C.E.S., is First Vice President of Bayview 1031.