How To Choose a Qualified Intermediary (Accommodator)

The Qualified Intermediary (often referred to as the Accommodator or Facilitator) is a crucial part in the administration of any 1031 Exchange transaction.  In order to save space in this blog post, I will refer to the Qualified Intermediary as the QI.  It is critical that investors exercise extreme care when evaluating and selecting their QI because of the crucial role that the selected QI will play in the administration of their 1031 Tax Deferred Exchange.

This blog post will help investors understand the risks involved in selecting a QI for the administration of their 1031 Exchange, and will provide sample questions investors can use to perform their due diligence of QIs.  The due diligence process for selecting your QI should never be taken lightly. 

The one thing we learned through The Great Recession is the size of the QI does not matter.  The business practices of the QI are what matters.  The integrity is what matters. 

Role of the 1031 Exchange Qualified Intermediary

Qualified Intermediaries, as detailed here in my resent blog post, are essentially responsible for: (1) drafting and coordinating the 1031 Exchange legal agreements and related transaction documents to structure the 1031 Exchange; (2) receiving, holding and safeguarding investors' 1031 Exchange proceeds/funds through the investor's 1031 Exchange; and (3) providing advise and guidance in conjunction with the investors advisors about the implementation of their 1031 Exchange to ensure compliance with applicable Internal Revenue Codes, Department of the Treasury Regulations and related IRS Revenue Rulings and Procedures.

Qualified Intermediaries Are Not Licensed, Regulated Audited or Bonded

Remember that QIs are generally not licensed, regulated, or audited, and are usually not required to be bonded, insured or maintain any kind of minimum levels of equity capitalization (with the exception of a few states that have recently enacted legislation). 

Investors should always complete a very thorough investigation of any QI (often referred to as due diligence or DD) before making their final choice.  Investors should never ever choose their QI based solely upon the 1031 Tax Deferred Exchange fees, costs and charges or by the size of the institution serving as a QI.

Investigative Process for Choosing Qualified Intermediaries

There is very little information regarding the administrative practices of QIs.  Investors often focus on less important issues such as the size of the QI, 1031 Exchange administrative fees, interest rates paid on 1031 Exchange funds, processing times, QI office locations, and so forth, when evaluating prospective QIs.  Many of these issues are in fact important considerations that should not be ignored, there are other more crucial issues investors must take into account before all others.

Identifying and Assessing the Critical Issues

The critical risk elements that investors must analyze before making their final decision on which 1031 Exchange QI to hire, includes, but are not limited to, the following elements:

• Technical competency (expertise) of the 1031 Exchange QI and amount of time (experience) they have been administering 1031 Exchange transactions
• Internal processes and audit controls to safeguard 1031 Exchange proceeds
• Use of Qualified Trust Accounts or Qualified Escrow Accounts
• Decision criteria and guidelines for investment of your 1031 Exchange Proceeds
• Protection from potential errors or omissions (E&O Insurance) by the QI
• Protection from potential theft or embezzlement  (Fidelity Bond) of 1031 Exchange proceeds

The comments that follow provide industry best practices that will be helpful to investors in analyzing possible 1031 Exchange QIs and in determining if audit, controls and safeguards are being practiced. 

Technical Competencies — Knowledge, Expertise, and Experience

Problems most often encountered by the 1031 Exchange industry today are due to the fact that many QIs do not have the technical depth, experience and expertise necessary to properly administer 1031 Exchange transactions.  1031 Exchange QIs are often processors and not advisors and consultants that can work with the investors' other professional advisors.  Many QIs know how to "administer" a 1031 Exchange but don't really understand what to look for when reviewing agreements and/or transaction documents.

The most important element to analyze is the QIs technical competency, including the QI's expertise and experience.  The slightest mistake could result in a disallowed 1031 Exchange and the taxation of significant taxable gains.

Investors must ensure that the 1031 Exchange QI's experts truly do have sufficient technical competency, knowledge, experience and expertise to assist in structuring their 1031 Exchange, including reviewing transaction agreements and documents for potential problems, and in the drafting of the 1031 Exchange agreements and related transaction documents.

Experienced 1031 Exchange QIs can easily identify potential problems with a 1031 Exchange and offer solutions to correct the problems before the problem becomes permanent.  Technical problems in the administration of a 1031 Exchange can not be corrected after the transaction has closed, so it is critical that problems be identified and solved before closing.

Investors should always interview prospective 1031 Exchange QIs.  Now is not the time to be shy or timid.  Ask lots of questions and compare the answers and technical depth of experience of the various QIs that you speak with in order to separate the true 1031 Exchange experts from the rest.  This is a critical step in choosing the best 1031 Exchange QI to administer the 1031 Exchange.

Policies, Procedures and Internal Audit Controls

I can not emphasize how important sophisticated policies, procedures and internal audit controls are in minimizing the risk of loss to a 1031 Exchange transaction and the related funds while being held, managed and safeguarded by your QI.  Internal audits and controls monitor and safeguard 1031 Exchange proceeds during the administration of 1031 Exchange transactions. 

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 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 issue that should be on the top of your due diligence list. 

• 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)?  
• Do you hold clients' 1031 Exchange funds in a segregated Qualified Trust Account or a Qualified Escrow Account?  
• 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?