How To Avoid Embezzlement In A 1031 Exchange Deal: William Exeter’s Due Diligence Advice

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I am neither an expert or a current tax/investor looking to complete a 1031 exchange and avoid the nasty capital gains taxes in the process. I am not an attorney, real estate broker, or qualified intermediary professional giving advice or performing 1031 exchanges. I am simply a conduit for information that hopefully will enlighten some people, inform others, and make aware all investors to the possibility of embezzlement of their life savings in a 1031 exchange deal gone bad.

My series on the 1031 Tax Group (Ed Okun) and Southwest Exchange (McGhan) have outlined the serious problems the 1031 exchange industry is suffering currently. In reporting on my findings, many readers have commented online and off on their substantial losses; some of these people have lost their life savings and retirement nest eggs to embezzlement.

Therefore I have attempted to provide a source of information about alternative investment tools to the 1031 exchanges, ongoing news about legislation of the industry, and information from industry professionals whose reputations are at stake due to the actions of the few illegitimate men within this niche.

The following is advice for consumers when performing their due diligence on a prospective 1031 exchange company. The author of this advice is William Exeter President and CEO of Diversified Exchange Corporation. His paper is titled “How to Evaluate and Select Your Qualified Intermediary (Accommodator).”

According to Exeter there are 3 major risks when considering a 1031 exchange:

1. Embezzlement or theft of the 1031 exchange funds
2. Errors or omissions in the administration of the 1031 exchange
3. Voluntary or involuntary bankruptcy filed by the Qualified Intermediary

One tip for avoiding possible embezzlement or theft, according to Exeter, is to verify that the QI maintains Fidelity bond coverage. The idea is to verify that the bond coverage is “in full force and effect and to determine the policy limits.” The consumer should request a copy of the QI’s insurance binder as well as the contact information of the insurance company/agent for the QI. When speaking to the insurance company ask the following questions: “Is the Fidelity bond coverage “per occurrence” or merely in “aggregate”?

In aggregate means that their is a policy limit based on an annual amount and limited to that dollar amount regardless of the number of thefts during the year. The “per occurrence ” means that each theft is covered up to the policy limit. According to Exeter, there can be a big difference in coverage between the two.

In regards to Errors and Omissions insurance, the consumer should take the same steps as outlined for their due diligence on a QI’s Fidelity bond insurance. Ask for a copy of the insurance binder and the QI’s insurance company contact information. Call and verify that the Errors and Omissions insurance is in fact “in force” and verify the policy limits.

“Bankruptcy is a rare event within the 1031 exchange industry” according to Exeter. Unfortunately it is possible and should be considered. The following information may help consumers perform their due diligence. This information may help consumers avoid having  their 1031 exchange funds lost in a bankruptcy case.

Consumers must ensure that their funds will not be held under their QI’s corporate name. If this is the case, then the consumer’s funds will be considered part of the bankrupt QI’s estate. This estate is then used to pay off any creditors owed monies by the QI.

The Department of the Treasury provides for Qualified Trust accounts or Qualified Escrow accounts. These accounts are considered “fiduciary funds and not subject to the bankruptcy estate or creditor claims.”

These tips and suggestions by Mr. Exeter are just a beginning taste of what each consumer must consider when performing their investigation on a Qualified Intermediary. Please remember to consult your tax professional or legal expert when performing this investigation process.

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5 thoughts on “How To Avoid Embezzlement In A 1031 Exchange Deal: William Exeter’s Due Diligence Advice

  1. Dean

    I have mentioned this before but do not be misled by bonds or E & O insurance.

    Yes a bond or insurance may provide some ultimate source of recovery if the funds are lost or stolen, but the only sure way to protect the exchange itself is to be sure that the funds are held in some fashion that requires the exchanger’s written consent to move them.

    E & O insurance and bonds of any kind cannot and do not prevent unauthorized movement of the funds, they only provide possible repayment for the lost funds.

    Never forget that exchanges have very strict time requirements and if the funds are not there when you need them to complete your exchange, neither a bond nor E & O insurance will ever provide sufficient protection to save your exchange. You may have a taxable event in addition to any actual loss of funds.

    All theft and loss of funds has occurred by QIs that commingle funds held and do not separate each exchange into its own segregated account,

    Instead of looking for bonds or insurance, instead (or in addition) always look for completely segregated accounts as well as some kind of joint control with the QI so you can be assured the funds will be there when you need them.

    Next, always ask what interest rate you are being paid on the funds held. Lost interest is nothing more than a hidden fee so when comparing QI fees, include the interest paid (or not paid) in your calculations.

  2. Rob,

    As usual excellent points and worth all consumers time to understand. Your emphasis on “control of accounts” and the problems that “comingling” can create are well noted. I agree that insurance will not help a consumer when the IRS is knocking on their door to pay taxes. I was only illustrating Mr. Exeter’s point because it is often not investigated by consumers aka requesting the insurance binder and contact information of the insurance carrier for the QI.

    Yes you are absolutely correct in saying that the insurance will not bail a consumer out. I hope everyone takes a close look at your advice and heeds it’s warning.

    Thanks again Rob please drop by more often!

    dean

  3. Okun’s company had bonds and insurance. A lot of good that did. We do not need regulation; we do NOT need QIs. They should be eliminated and exchangers should be able to hold their money for 180 days and sign the necessary paperwork with the IRS for buying up. Remember years ago that you were allowed to buy up on your primary residence with out paying the tax? Well why can’t people hold their own money until it’s put into the next property with in the 180 days? Get rid of the QIs. The IRS should just make that one little change.

  4. Dr,

    Check out the comment above by Rob Egenolf. He addresses your concern about insurance and Rob adds some solid advice.

    I love your idea! Does anyone know why these deals could not be done by the homeowner if it was a buyer/seller beware understanding? Sort of like a FSBO for 1031 exchanges?

  5. While I actually agree that some sort of roll-over provision like old IRC §1034 (the old personal residence roll-over) might be a far more logical alternative (and also cheaper and safer as pointed out) to the current required structure, it is unlikely to happen if Congress take an in depth look at exchanges.

    Once an exchanger has his received all the proceeds of the sale, as would happen if a roll-over were to be used, it is difficult to “unring” the bell of taxability.

    I believe that it is far more likely that they will eliminate tax deferred exchanges entirely.

    Given the exponential growth of the TIC industry and the fact that most TICs are securities and not truly real property, extreme scrutiny of exchanges by Treasury and Congress is certainly becoming far more likely.

    I think a valid argument could be advanced that exchanges actually create more taxable events than the taxes deferred in the transactions themselves (through commissions, title and closing fees and other taxable events, however the CBO could nonetheless look at elimination of tax deferred exchanges as a revenue raiser that could be used to offset other tax cuts.

    We need to be very careful what we ask for here.

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