FEATURE ARTICLE, SEPTEMBER 2004

ARE YOU ASKING THE RIGHT QUESTIONS?
What should you know about your like-kind exchange services provider?
David DeRoberts

In recent years, increasing numbers of real estate owners have taken advantage of the substantial tax benefits of like-kind exchanges. While most real estate professionals understand the basics of Internal Revenue Code Section 1031, which allows taxpayers to defer capital gains from the sale of business/investment property, often little attention is paid to selecting a qualified intermediary (QI).

There are hundreds of exchange services providers in the United States. While the overwhelming majority of exchange services providers are honest and competent, it is best to exercise due caution in your selection. Before you deposit sale proceeds with a QI, whether the amount is $20,000 or $20 million, you need to do your homework.

Is the QI “qualified”? Qualification is the threshold issue. Certain persons or entities are legally disqualified from facilitating some exchanges. IRS regulations state that any person “who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker” within 2 years prior to the exchange is disqualified.1 However, a “financial institution, title insurance company, or escrow company” that has provided “routine financial, title, escrow, or trust services for the taxpayer” is not disqualified.2 The IRS Regulations further clarify that a bank-owned exchange company is not disqualified from providing exchange services to clients who have received investment banking or brokerage services from the parent bank.3 Finally, close relatives of, and entities owned by, the exchangor are also disqualified.

What is the QI’s reputation? Many QIs, such as financial institutions and title insurers, are affiliated with public companies. Detailed information about these entities can be accessed through a quick Internet search. Obtaining information about stand-alone firms requires the client to ask pointed questions and seek references from former clients or their advisors.

What is the QI’s experience and knowledge level? While a QI cannot replace professional tax and legal advisors, a knowledgeable one can be the key to a successful exchange. An experienced QI can spot issues and avoid activities that might otherwise disqualify a transaction. Your QI should be up-to-date on industry practices and governing regulations. The QI should also understand and provide a full range of exchange services, including reverse and construction exchanges. Professional designations are another indicator of a QI’s knowledge. The Federation of Exchange Accommodators issues the “Certified Exchange Specialist” designation to QIs that meet certain requirements and pass an examination. Most Certified Public Accountant (CPA) societies and bar associations also issue designations for tax or real estate specialties.

What level of service does the QI provide? A good QI will promptly confirm receipt and investment of proceeds, provide account statements, alert the exchangor to impending 45- and 180-day deadlines, and process disbursement requests in a timely and efficient manner. The QI should be available during your working hours, regardless of differences in time zones.

Does the QI supply all documentation? Most QIs provide their own exchange documents. These should contain all terms and provisions required under IRS safe harbor regulations. They should be drafted or approved by reputable outside counsel. Some QIs have an opinion letter on their documents from outside counsel. In addition to the exchange agreement, the QI should provide assignments, notices of assignments, replacement property identification forms, wiring instructions, and a disbursement request form.

How are proceeds invested and who gets the interest? Proceeds should be held in segregated accounts in an investment that is secure and liquid. Section 1031 allows exchangors to receive interest on invested proceeds. Some QIs provide that all income goes to the client. Others take all or some of the interest. Still others pool and invest exchange funds in their name, passing on a fraction of the earnings to their clients. This last course presents certain risks. A bankruptcy court recently ruled that an exchangor’s proceeds could be seized and paid to the QI’s creditors.4 The court noted that the QI pooled all funds of all exchangors in one account under the QI’s name, that the exchange agreement did not require funds to be segregated and allowed the QI complete discretion as to investment, and that the funds were intermingled with the QI’s to such an extent that tracing was impossible.5 Thus, manner of investment is critical.

Does the QI have procedures in place to prevent fraud and misuse of funds? The QI should have procedures in place to safeguard your funds. Examples include obtaining a list of client’s authorized signatories, internal confirmation of disbursements, calling client to confirm outgoing wire requests, internal/ external audits of exchange accounts and dual control of all critical activities.

Is the QI bonded and insured? The prudent exchanger should confirm that the QI is covered by Errors and Omissions insurance and a surety bond. However, it is important to understand that these are subject to certain coverage exclusions and do not always protect exchange clients from a QI bankruptcy.

Is the QI solvent? In some instances, bankruptcy trustees or judgment creditors have been able to seize exchange proceeds to satisfy the QI’s creditors.6 Many QIs are subsidiaries of public companies whose financial information is available online. In many instances the QI’s size and reputation can be indicators of solvency. The QI should be willing to establish an exchange agreement under the Qualified Trust or Qualified Escrow safe harbors which make it less likely that the QI’s creditors will gain access to proceeds held on behalf of exchangors. Although these safe harbors should protect funds in the case of insolvency, bankruptcy proceedings may delay the exchange beyond the deadlines and consequently invalidate it.

David DeRoberts is an attorney and a vice president with Bank One Exchange Corporation, an affiliate of J. P. Morgan Property Exchange, Inc.

©2004 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.