The importance of prudent cash mgmt. in 1031 exchanges

Given the recent conditions in the financial markets today, one of the most significant concerns for taxpayers performing 1031 tax deferred exchanges is the security of the funds held by the Qualified Intermediary (QI). To evaluate the extent of the security, it is important for taxpayers to recognize the role a QI plays in the exchange process and the due diligence questions to be asked before selecting a QI. Surprisingly to many taxpayers, the QI industry is largely unregulated. With the exception of a couple of western states, QIs are not subject to licensing or other certification requirements. Consequently, the careful selection of the QI is essential to ensure the highest levels of security for exchange proceeds. Given that financial security is the paramount concern today, taxpayers should find out exactly where exchange funds are going to be deposited and invested by the QI. However, given that accounts at federally regulated financial institutions are only insured up to $250,000 per depositor, even FDIC insurance doesn't necessarily provide taxpayers with a great deal of comfort. Accordingly, in selecting a QI, taxpayers should ask the following: * Does the QI have a written investment policy that dictates how funds must be invested at all times? What are the stated objectives of this investment policy? A prudent approach would be an investment policy that preserves capital and minimizes risk of the invested funds, including credit risk, interest rate risk and appropriate diversification and concentration risk. The investment should at all times provide the liquidity needed in a timely manner to accommodate the 1031 exchange process. * What specific types of investments can be made by the QI under the investment policy? Are funds only invested in financially sound investments such as U.S. Treasury and Agency Securities, AAA Rated Money Market funds having at least $1 billion in asset bank deposits, etc? Are the investments sufficiently rated by at least two Nationally Recognized Statistical Rating Organizations (NRSROs) such as Moody's, Fitch or S&P? * What methods of external verification over the banking processes and fund management are implemented? Does the QI undergo banking and financial audits by an accounting firm covering the books, records and procedures of the QI? Are these audits done internally or externally? Does an independent and nationally recognized outside accounting firm also perform an annual audit of the QI? * What types of internal controls and checks and balances are implemented by the QI to protect 1031 funds? Are there criminal and background checks on each employee? * Are all exchange funds held in separate accounts from operating accounts that ensure 1031 exchange funds cannot be attached by creditors of the QI in the event of a voluntary or involuntary bankruptcy filing? Does each taxpayer receive a unique account number and monthly statements of the account balance that detail accrued interest? * What are the policies regarding transferring funds out of an account? Is the authorization of the taxpayer required to move funds at all times? Are there internal controls so no one person at the QI can withdraw funds? * What types of insurance coverage are maintained to ensure against employee theft or embezzlement of exchange funds? Is the fidelity bond coverage "per occurrence" or "in the aggregate" and if it's "in the aggregate" is it over the term of the policy? Does the QI maintain sufficient E & O insurance coverage to insure against errors and omissions that might result in a loss? Do the QI's fidelity bond and E & O policies cover just the QI or do they cover related entity operations that might diminish the overall protection to the taxpayer in the event of multiple losses throughout the consolidated entity? * Is the QI owned or backed by a credit-worthy third party with transparent financials and consistently high financial ratings? It is prudent to have such a written commitment from a large creditworthy entity indicating that the funds held by the QI are being backed by such significant financials. Pamela Michaels, Esq., is an attorney and VP of Asset Preservation, Inc., Manhattan, N.Y.