The Qualified Intermediary provision of the Section 1031 Like Kind Exchange is the only flaw in an otherwise perfect system.
But it is a fatal flaw.
Whatever you do, do not sign any document turning over your Net Sales Proceeds to a Qualified Intermediary to put into his own account until you have the advice of an Attorney.
Please.
This is serious!
When you sell your investment property in a Section 1031 Exchange, the IRS requires that your Net Sales Proceeds be held by an independent third party called a Qualified Intermediary.
Those funds can easily be lost or stolen.
Qualified Intermediary Middleman
Section 1031 of the Internal Revenue Code allows you to sell “real property held for productive use in a trade or business or for investment,” called your Relinquished Property, and defer taxes on the Capital Gains, your profit.
This is done by purchasing another property, called the Replacement Property, within 180 days, using the Net Sales Proceeds from the sale of the Relinquished Property.
One of the Section 1031 Exchange rules, however, requires that an independent third party must take possession of the Net Sales Proceeds from the sale of your Relinquished Property, and hold them until the closing on the purchase of the Replacement Property, so that you personally never have possession of, nor control over, the funds.
The problem here is that the IRS requires you to use someone called a Qualified Intermediary to hold these funds.
Qualified Intermediary Escrow Account
The Qualified Intermediary is the one fatal flaw in the Section 1031 Exchange law.
The term “Qualified Intermediary” was chosen by the IRS to refer to the independent third party handling your Net Sales Proceeds.
“Qualified” does not mean that they are actually QUALIFIED.
The IRS has no idea whether they are qualified or not.
The IRS uses “Qualified” to mean that they are not disqualified by being a member of your family, or by being, or having been, your agent. (Like a total stranger will take better care of your funds than someone with whom you have a personal or professional relationship.)
“Qualified” means that it is OK with the IRS for them to handle these funds because they are not disqualified from doing so, but does not mean that the IRS has determined that they are actually qualified in a professional sense to do so.
For individuals acting as Qualified Intermediaries, there is no federal licensing or oversight, and most states have none. But about eight states now regulate Qualified Intermediaries (bonding, insurance, penalties), and Nevada requires a license.
But even the rules that exist are thin protection.
The Qualified Intermediary has your money because you have signed an agreement with them.
Your funds are usually held by the Qualified Intermediary in their name, in a commingled account, along with the Exchange funds of other taxpayers.
These funds are sometimes lost or stolen by the Qualified Intermediary.
And these lost or stolen funds are not by small, fly-by-night operators.
Read on.
Missing Funds and the Qualified Intermediary
On November 24, 2008, LandAmerica 1031 Exchange Services, Inc. (LES), one of the five largest Qualified Intermediaries in the country, filed for Bankruptcy, and all of the customers’ funds being held for closings were immediately frozen.
LES claimed initially that the total value of the customers’ funds was sufficient to cover the planned closings, but that the funds had been invested in “auction grade securities” and that “due to a recent freeze in the credit market” the funds were not liquid.
And most LES customers believed that their funds would be released at the first meeting of the Bankruptcy Court.
The reality turned out to be somewhat different.
In fact, the market for auction grade securities had collapsed.
And on the same day that LES filed bankruptcy, the parent company of LES, LandAmerica Financial Group, a Fortune 500 Company and the third largest Title Company in America, possibly realizing the size of the problem and knowing that it had guaranteed some of LES’s obligation to some of the Exchange clients, also filed for Bankruptcy protection.
It turned out that LES was holding about $450M in funds for Section 1031 Exchange closings for about 450 customers.
And the Bankruptcy Court was not releasing any of the money.
Most of the customers’ Section 1031 Exchange transactions had already failed by the time the Bankruptcy Court, five months later, handed down their ruling.
The Bankruptcy Court ruled that $400M of “the customers’ funds” were not the customers’ funds, but were actually owned by LES, and that those funds would be used to pay the company’s debts to its secured creditors.
The remaining $50M would be applied toward the unsecured claims against the company, which now included the $450M in claims of the customers.
Escrow Account Safety
So, how do you protect yourself?
First, don’t accept the assurances of the Qualified Intermediary about their honesty, integrity, and responsibility even if it might be true.
LandAmerica was the most respected intermediary in the business.
And not only did they lose $450M of their customers’ money, but they put their customers in the position of being liable for another $100M in Capital Gains and Depreciation Recapture taxes on income that they never received.
Second, insist that your funds be held in an FDIC-insured financial institution account in amounts covered by the FDIC insurance limits.
The Internal Revenue Code does not stipulate what a Qualified Intermediary can and cannot do with the taxpayer funds.
Third, insist that the funds be held in your name.
There are two ways that these funds be held, and the choice is up to you.
The funds can be held in a Qualified Escrow Account or in a Qualified Trust account.
Qualified Escrow Account and Qualified Trust Account
A Qualified Escrow Account is where your Escrow Agreement with the Qualified Intermediary expressly limits your rights to receive, pledge, borrow, or obtain any benefits from funds held in the escrow account, but the funds are held in your name and not the name of the Qualified Intermediary.
A Qualified Trust is just what it says, a Trust, and you are the Beneficiary.
And, like with the Qualified Escrow Account, the Trust Escrow Agreement limits your rights to receive, pledge, borrow, or obtain any benefits from the funds.
By the way, it is not sufficient that the Qualified Intermediary hold the funds in a segregated account in your name. The QI is still the owner of the account. So don’t fall for that.
The Bankruptcy Court has ruled that such funds still belong to the Qualified Intermediary, not the customer.
The Court will look at the terms of the Escrow Agreement that you sign with the Qualified Intermediary, and most of the Agreements being used today stipulate that when you turn your funds over to the Qualified Intermediary, you disclaim “all rights, title, and interest” in the funds.
Escrow Account Agreement
To protect yourself, your Escrow Agreement should involve three parties, not just you and the Qualified Intermediary.
The third party in a Qualified Escrow Account is the “escrow holder.”
The third party in a Qualified Trust is the Trustee.
The Agreement should require that the escrow holder or Trustee receive the taxpayer’s written authorization for a withdrawal.
This way, you satisfy the requirements of Section 1031 that you not have receipt of, constructive receipt of, or control over the Net Sales Proceeds, and also satisfies the requirement that they be held by an independent third party.
But you also protect your funds by not allowing them to become the asset of the Qualified Intermediary, so that they might be lost or stolen.
And finally, although there might be a state law that empowers the taxpayer to terminate or dismiss the escrow holder of the Qualified Escrow Account, or the Trustee of the Qualified Trust, these rights are overridden in this situation by Treas. Reg. 1.1031(k)-1(g)(3)(iv).
The IRS has made many changes to the Section 1031 Like Kind Exchange law over the years, and has lessened the burden on the taxpayer when the Qualified Intermediary files bankruptcy. For details, look at Rev. Proc. 2010-14, the safe harbor that lets a taxpayer defer gain when a Qualified Intermediary defaults or goes bankrupt.
But the IRS has consistently failed to deal with the major flaw in the system, the participation of a Qualified Intermediary.