A recent spate of bankruptcies and failures in the IRC Section 1031 Qualified Intermediary ("QI") industry has spurred a flurry of articles by practitioners warning Taxpayers to conduct vigorous due diligence before settling on a QI provider. 
 
In our view, security of funds in a 1031 exchange is a multi-dimensional issue and Taxpayers need to be mindful of a number of things:
 
How is Your Exchange Account Structured?
 
As you've heard from us previously, the qualified trust safe harbor (provided an express trust is created under local law) segregates the funds from the assets of the trustee and the assets of the QI, by operation of law, eliminating the possibility that the funds would be included in the bankruptcy estate of either the trustee or the QI.
 
The trust structure should, practically speaking, eliminate the issue of the QI's financial net worth.  The proceeds are not and should not be on the QI's balance sheet because the  proceeds remain the property of the Taxpayer. And provided the Qualified Trust Agreement contains the appropriate limitations on the Taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the funds during the exchange period (as contained in Treasury Regulation 1.1031(k)-1(g)(6)), you can neatly and tidily discharge the issue of constructive receipt.
 
Additionally, the qualified trust safe harbor should eliminate concerns over the trustee's solvency.  In the event the financial institution or bank that is acting as trustee is seized by the FDIC, the assets held in trust are not assets held on the bank's balance sheet and cannot be reached or otherwise made available to general creditors of the bank. 
 
What About FDIC Insurance?
 
In October of 2008, the FDIC rolled out their "Transaction Account Guarantee Program" which provides 100% deposit insurance coverage for non-interest bearing transaction deposit accounts at FDIC-insured institutions that have elected to participate in the program. This unlimited insurance coverage will expire on December 31, 2009, fewer than 180 days from now,  and is an option many Taxpayers are currently using.
 
While FDIC insurance will protect certain depositors from a bank's insolvency, Taxpayers must still be cognizant of the type of account through which the deposit is made. Is the account owned and controlled by the QI?  Is the account titled in the name of the Taxpayer? Is the account a liability on the QI's balance sheet? 
 
If the QI files for protection from its creditors under Chapter 11 of the U.S. Bankruptcy Code, are those funds at risk of being included in the QI's bankruptcy estate?
 
Many QIs eschew the qualified trust structure as being too expensive, too cumbersome, or too inflexible for their purposes and opt for non-interest bearing bank accounts. While providing protection to the Taxpayer from the bank's insolvency, these accounts may not provide protection from the QI's bankruptcy.
 
How Are the Funds In The Trust Account Invested?
 
Once the funds are safely deposited into the trust account, the secondary issue becomes where and how are those proceeds invested?  A bankruptcy-remote trust account will be of limited practical use if the proceeds are invested in illiquid securities and the cash is unavailable to fund the replacement property acquisition.
 
In at least two of the recent QI bankruptcies, the investment options used by the QI were auction rate securities - derivative financial instruments created from long-term bonds that were rated and sold as "cash equivalent" investments.  When demand for these instruments evaporated, thousands of investors were left holding pieces of long-term fixed income securities with no readily available marketplace in which to sell.
 
Money market funds have always been considered safe, cash equivalent investments. The objective of a money market fund is to maintain a stable, net asset value of $1 while providing a return slightly higher than a bank savings account. Indeed, many large funds will, when needed, take losses to keep their share prices stable at $1. 
 
In September 2008, the Reserve Primary Fund, one of the oldest and largest money market funds, "broke the buck" - the net asset value of one share invested in the fund dropped below $1 - and froze redemptions for a period of time, an event that had occurred only one other time in the history of money funds. 
 
In response to the September 2008 event, the SEC issued proposed rule amendments to strengthen the regulatory framework for money market funds.  The proposals include the possibility that shares could be purchased and redeemed at something other than $1 per share, in order to allow investors to get their funds back more quickly if a fund breaks the buck.
 
Can Investment Risk Be Eliminated?
 
Indeed, four-week or three-month Treasury bills will eliminate investment risk and can be purchased with laddered maturities to meet liquidity needs.  Alternatively, to avoid having to cash in your T-bills prematurely, you could also consider a Treasury-only money market fund. (However, call ahead as many Treasury funds are currently limiting new admissions due to the overwhelming demand for these investments). And in today's interest rate environment, with the Fed-funds rate at a historical low of between 0% and 0.25%, you may not care that your T-bills or your Treasury-only money market fund are yielding a fraction of a percent.
 
Set Yourself Up for Success
 
Don't lose sight of your overarching objective. Make sure the transaction is structured properly so your tax objectives are achieved, your proceeds are segregated from creditors' claims, and invested only in highly liquid secure instruments. Ask difficult questions. You'll never be sorry.