Due Diligence on a QI

As the financial press focuses on Bernard Madoff and other Ponzi schemes, recent investor losses approaching $1 billion by the failure of qualified intermediaries have gone relatively unnoticed. Qualified intermediaries, or QIs, facilitate tax-deferred exchanges of like-kind property under section 1031 of the Internal Revenue Code.

Some QIs have made allegedly imprudent investments in recent years, while others have allegedly siphoned off funds to related parties and are facing criminal charges.

Investor/taxpayers in these cases often not only lose the proceeds from the sale of their exchanged (and not yet replaced) property, but the exchange is deemed to be invalid, triggering a taxable event. Thus, due diligence is necessary before selecting a QI. Here are some points to include in such an inquiry:

  Identify the type of entity in which the QI operates. Check records in the QI’s state of incorporation to ensure that it is registered as a corporation in good standing. Any QI operating as an unincorporated entity could expose the transaction to legal problems resulting from personal liability or death of the QI.

  Obtain resumes of all owners and management personnel. If necessary, obtain civil and criminal background checks. Consider how long they have been in the industry. Determine if they are members of professional organizations such as the Federation of Exchange Accommodators and whether they are Certified Exchange Specialists.

  Determine the range of services the QI offers. Obtain the type, number and dollar volume of exchanges completed over the past three years. Look for a range of types of transactions, indicating breadth of experience.

  Obtain the QI’s financial statements for the past three years. If the QI is a member of a larger entity, obtain consolidated financial statements. Obtain copies and explanations of the QI’s bond agreements, error-and-omissions policy and any other insurance.

  Obtain the names of accountants, attorneys and professional advisers on staff or retainer as well as banking references. Determine if these advisers are in good standing with their respective regulatory agencies. Verify the bank references.

  Obtain a copy of the QI’s investment policy statement (IPS). The IPS defines what the qualified intermediary can invest in and how the QI measures risk. Evaluate the diversification, liquidity and safety of the potential investments.

  Obtain a fee disclosure for all benefits the QI receives as a result of the relationship with the taxpayer. These include whether referral fees are paid on received funds to company attorneys, real estate agents, CPAs or other professionals.

  Verify that the proceeds are held in separate accounts in highly rated, FDIC-insured banks.

  Verify that taxpayers’ relationship with a bank is transparent, that they may receive confirmations and view their account balances online. Monthly statements may also come from the QI as well as the bank.

  Verify that the QI uses qualified trusts and escrows with independent trustees and escrow holders.

  Ensure that the QI requires taxpayer signatures for all withdrawals. This may be a single form from the exchange agreement or signature on the release for the bank.

This is not an all-inclusive list, but it does highlight some of the best practices of doing business with QIs. Review the answers annually or when there are significant changes for the QI, the industry or state laws.

—By Donald M. Deans, CPA/PFS, CFS, a financial consultant, and William B. Nicholson, ChFC, an advanced planning specialist, both at Capital Investment Cos. In Raleigh, N.C. Their e-mail addresses, respectively, are ddeans@capital-invest.com and bnicholson@capital-invest.com.