The Intermediary Industry

This chapter takes up that gap: what the federal rules require, what happened when the gap was tested, what a minority of States have done about it, and what a practitioner should ask before recommending anyone.

55.1 Custodial risk and the absence of federal regulation

The federal definition is two conditions long. A qualified intermediary is a person who is not the taxpayer or a disqualified person, and who enters into a written agreement with the taxpayer and, as required by that agreement, acquires and transfers the relinquished property and acquires and transfers the replacement property.¹

What the definition does not contain is the whole of this chapter. There is no licensing requirement. No minimum capital. No bonding requirement. No insurance requirement. No audit. No examination. No requirement that exchange funds be segregated from the intermediary's own assets or from those of other clients. No restriction on how the funds may be invested. No reporting to any federal regulator.

A qualified intermediary in the federal tax sense may be a limited liability company formed the previous week, with no assets, no employees, and no obligation to keep a client's money anywhere in particular.

The regulation does require one thing that looks protective and is not. The exchange agreement must expressly limit the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the funds.² That restriction exists to prevent constructive receipt, and its effect is to place the money beyond the taxpayer's reach for up to one hundred eighty days. It protects the tax result by removing the taxpayer's control, and it does nothing to protect the money.

The default investment rule points the same direction. Exchange funds are treated as loaned from the taxpayer to the exchange facilitator, which takes into account all items of income attributable to them, unless the agreement provides that all earnings attributable to the taxpayer's funds are paid to the taxpayer.³ The Code's own framing of the ordinary arrangement is a loan to the facilitator, which is an accurate description of the taxpayer's position and an uncomfortable one.

The practical summary for a client is short. Federal tax law tells you who may hold your money. It does not tell you that they will give it back.

55.2 The 2008 insolvency wave and what it exposed

The gap was tested in 2008, and the leading failure is worth recounting from the company's own filings rather than from secondary accounts, because the details are more instructive than the summary.

On November 24, 2008, LandAmerica 1031 Exchange Services Company, Inc. wrote to its customers that it was accepting no new customers and was terminating operations. The letter is short and it explains exactly what went wrong:

Although the total par value of our 1031 exchange funds exceeds the value of all funds received from our customers, portions of the 1031 funds are invested in illiquid auction rate securities. Our inability to sell or borrow against these securities has precipitated our decision to terminate operations.⁴

The letter went on to explain the investment policy, and this is the part practitioners should read twice. The company had long invested exchange deposits only in investment grade securities rated A or stronger, including auction rate securities backed by federally guaranteed student loans, and its stated goal had been to maintain the full liquidity necessary to meet customer withdrawal demands. Those securities had been highly liquid for years. The auction rate securities market froze earlier in 2008, and that prevented liquidation.⁵

Two days later, on November 26, 2008, LandAmerica Financial Group and its wholly owned subsidiary the 1031 Exchange Company filed voluntary petitions under Chapter 11 in the Eastern District of Virginia.⁶

Four lessons, and none of them is that the money was stolen.

The funds were not misappropriated and were not junk. They were investment grade, federally guaranteed, and highly rated. They were simply not saleable on the day the customers needed them.

A one hundred eighty day deadline does not accommodate illiquidity. A taxpayer whose funds are unavailable for six months has a failed exchange whether or not the funds are eventually recovered in full. The deadline of Chapter 26 does not toll for a custodian's difficulties, as 26.3 establishes.

Commingling converts an individual problem into a collective one. Funds pooled across customers and invested as a single portfolio meant that no customer's exchange could close, rather than that some could.

The parent company's bankruptcy reached the exchange subsidiary. The 1031 subsidiary filed alongside its parent, and customers became unsecured creditors in a Chapter 11 case rather than beneficiaries of a segregated account. That is the risk the qualified escrow and qualified trust structures examined at 55.4 exist to address.

The taxpayers affected faced the compound outcome described at 51.3. Their relinquished properties had been sold, their gain was realized, their exchange periods were running or had run, and the money that would have both completed the exchange and paid the resulting tax was in a bankruptcy estate.

55.3 State licensing, bonding, and insurance regimes

A minority of States responded, and the response is uneven. The States commonly identified as regulating exchange facilitators include California, Colorado, Idaho, Maine, Nevada, Oregon, and Washington. The great majority of States impose no requirements at all, and a practitioner should verify the current law of the State in question rather than rely on any list, including this one.

Maryland does not appear among the States that regulate exchange facilitators. A practitioner should confirm that rather than assume it, and should understand its consequence: a Maryland exchange is governed by the federal definition of 55.1 and by nothing else, unless the intermediary happens to be organized in or subject to the law of a regulating State. The Maryland questions that do arise, which concern withholding, transfer and recordation taxes, and ground rent, are the subject of Chapter 61.

The Washington statute is worth setting out because it is the clearest example of what regulation looks like when it exists, and because its structure is a template a practitioner can apply as a diligence standard anywhere.

A person who engages in business as an exchange facilitator must either maintain a fidelity bond of not less than one million dollars, executed by an insurer authorized to do business in the State, for the benefit of a client suffering a direct financial loss as a result of the facilitator's covered dishonest act, covering the acts of employees and of owners of a nonpublicly traded facilitator; or deposit all exchange funds in a qualified escrow account or qualified trust as those terms are defined in the deferred exchange regulation, with a financial institution.⁷

Where the escrow or trust route is taken, the statute adds two safeguards that go beyond the federal rules. A withdrawal of exchange funds requires the facilitator and the client to independently authenticate a record of the transaction. And the client must receive, independently from the depository institution and by any commercially reasonable means, a current statement verifying the deposited funds.⁸

The statute also requires the facilitator to disclose the substance of these requirements on its website and in its contractual agreement, in conspicuous typeface.⁹

Two observations about that scheme.

It is an either-or. A facilitator may bond against dishonesty or it may hold the funds in a structure the taxpayer can verify. The second alternative is stronger, because it protects against insolvency and illiquidity as well as against theft, and 2008 was a failure of liquidity rather than of honesty.

The independent authentication and independent statement requirements are the two features that would have made the greatest practical difference in the 2008 failures, and they are entirely absent from federal law.

55.4 Fidelity bonds, segregation, and qualified escrow

Three protections are available and they address different risks. Confusing them is the most common error in this area.

A fidelity bond protects against dishonesty. It responds to theft, embezzlement, and similar covered dishonest acts by the facilitator, its employees, and in a well drafted policy its owners. It does not respond to insolvency, to an investment that becomes illiquid, or to a parent company's bankruptcy. A facilitator that loses client money honestly has not triggered the bond.

Errors and omissions insurance protects against negligence. It responds to professional mistakes, including missed deadlines and defective documents. It does not respond to the loss of funds.

Segregation and a qualified escrow or trust protect against everything else. Where the funds sit in an account at a depository institution, in the taxpayer's name and identification number, subject to a qualified escrow agreement or qualified trust that the taxpayer can verify, the exposure to the facilitator's own finances is largely removed.

The federal structure for that already exists and is examined at 27.2 and 27.5. A qualified escrow account requires an escrow holder who is not the taxpayer or a disqualified person and an escrow agreement that expressly limits the taxpayer's rights.¹⁰ A qualified trust requires the same of the trustee and the trust agreement.¹¹ More than one safe harbor may be used in the same exchange provided the terms and conditions of each are separately satisfied,¹² which is precisely the combination this section recommends: an intermediary for the agency problem, and a qualified escrow or trust for the custody problem.

The definitional provision that makes the combination possible is the sentence at 27.5 stating that the term taxpayer does not include a person utilized in a safe harbor.¹³ Because the intermediary is not the taxpayer, an escrow holder holding funds for the intermediary is not holding them for the taxpayer, and the account may qualify.

A separate document also matters. The default rule treating exchange funds as loaned to the facilitator is displaced where all earnings attributable to the taxpayer's funds are paid to the taxpayer, and the strongest version of that arrangement is a separately identified account established under the taxpayer's name and taxpayer identification number with a depository institution.¹⁴ An account in the taxpayer's own name and number is both a tax position and a custody protection, and asking for it costs nothing.

55.5 Diligence standards for selecting an intermediary

The federal rules impose no diligence obligation, and counsel's professional obligations are a separate matter taken up in Chapter 56. What follows is the set of questions that would have distinguished a safe intermediary from an unsafe one in 2008, and that continue to do so.

Where are the funds held, and in whose name? A separately identified account at a depository institution, in the client's name and taxpayer identification number, is the strongest answer. A commingled pooled account is the answer that failed.

How are the funds invested? The answer should be a deposit account or an instrument that is liquid on any business day. "Investment grade" is not the standard; saleable within one business day is the standard, and 2008 established the difference.

Who must authorize a withdrawal? The Washington model requires the client's independent authentication.¹⁵ Where that is available it should be required, and where it is not, the reason should be understood.

Does the client receive statements directly from the institution? Independent verification from the depository, rather than a report from the facilitator, is the check that detects a problem while there is still time.

Is there a fidelity bond, in what amount, and covering whom? Owners as well as employees, and an amount that bears some relation to the funds held rather than to a statutory minimum.

Is there errors and omissions coverage, and in what amount? For the different risk described at 55.4.

What is the intermediary's own balance sheet, and what is its parent? The 2008 failure came through a parent's bankruptcy. An intermediary whose parent is in a cyclical business is exposed to that cycle.

Is the intermediary a disqualified person? This is the only question the federal rules actually require, and it is answered under Chapter 28 against the lookback date. It is also the question most likely to be answered wrong, because the relationship that disqualifies is often the taxpayer's own long standing advisor.

A closing observation for counsel. A lawyer who recommends an intermediary has made a recommendation, and the client will remember it. The safer practice is to present criteria and two or three candidates who satisfy them, to record what was asked and what was answered, and to let the client choose. The professional responsibility dimension of that, including the disqualification bar that prevents the lawyer from serving in the role, is the subject of Chapter 56.