Improved Asset Security

In every 1031 exchange, whether deferred or reverse, the Exchanger entrusts valuable assets to their Accommodator. In the case of a deferred exchange, the cash proceeds from the sale of the Old Property are held by the Accommodator until the purchase of a New Property is closed. In the case of a reverse exchange, the Accommodator holds legal title to either the Old or the New Property, depending on the form of the reverse exchange. Exchangers should be diligent in selecting an Accommodator that has security provisions in place that meet their requirements.
If the exchange is a delayed exchange and the asset is cash, the following basic diligence questions are highly recommended:

The Exchanger should verify that the cash is held in a regulated financial institution (e.g. a bank), that the funds are liquid, that the investment policy used for the funds has a risk profile that is acceptable to the Exchanger and that the process for disbursing funds requires, at a minimum, explicit authorization from the Exchanger. Currently, many Exchangers are requiring an escrow or trust structure in addition to the above protections.
Exchangers should also verify that a delayed exchange Accommodator has sufficient insurance to protect its clients from acts of dishonesty (a Fidelity bond) and errors in execution (An Errors and Omissions policy). When cash is held, both a Fidelity Bond and an E&O policy should be required. In simple terms, a Fidelity bond will provide protection if assets are stolen and E&O insurance provides protection if the Accommodator makes a mistake. As an aside, the FEA currently sponsors a Fidelity bond program for its members. The amount of insurance each Accommodator buys is the maximum amount that the insurer will pay if there is a claim. This means, hypothetically, that if an Accommodator has a $10 million Fidelity bond and has more than $10 million in exchange deposits in the aggregate on deposit, then there may be exposure to the Exchangers if an act of fraud occurs. There are real examples of this in the works today. Exchangers should be fully aware of the risks resulting from an Accommodator having a Fidelity Bond that is too small (i.e. less than their aggregate exchange proceeds balance).
Finally, Exchangers should ensure that their Accommodator has protections in place in the case of bankruptcy or insolvency. The segregation of assets into qualified trust accounts or other similarly structured depository accounts is useful in this regard. Also, some diligence by Exchangers with regard to the financial condition of the Accommodator they are considering is certainly warranted. In short, Exchangers should make sure their Accommodator is healthy and going to be around for the long-term.

The result of not doing basic diligence of this nature can be disastrous. Click here to learn more.

Asset Security in a Reverse Exchange

Reverse exchanges provide a level of security for Exchangers that deferred exchanges simply cannot provide because:

No Cash Accumulation. Cash in a reverse exchange is generally required only at the time of final settlement. This means that the Accommodator (or preferably its escrow agent) holds the cash long enough to satisfy the §1031 requirements for the involvement of a QI in a simultaneous exchange. This typically means that funds are wired in and out of a QI account within a 24-hour period. With no accumulation of cash balances, there is far less risk.
Execution Assurance. In ExStra exchange documents, there are binding agreements that mandate the return of the parked assets. We provide further assurance, at the request of the Exchanger, by 1) recording the Exchanger’s “call option” in a real estate exchange with the appropriate local jurisdiction and/or 2) developing, pre-executing and placing into escrow, with appropriate instructions, the documents required to complete the exchange.
More Bankruptcy Remote. The Exchanger should ensure that the parked asset is held in an LLC that has been formed specifically for their exchange and that no other assets have been or will be held by that LLC. In addition, the Exchanger should be granted a 100% security interest in the LLC. LLCs provide some level of bankruptcy remote-ness by definition. However, additional provisions should be made to ensure that a bankruptcy of the member of an LLC in a reverse exchange (typically the Accommodator) does not entangle the LLC and its assets needlessly for a lengthy period of time. Each Exchanger should be assured that their reverse exchange will never be subject to the dispositions of a bankruptcy court due to a failure of the Accommodator’s delayed exchange business. ExStra uses a 2-tier EAT structure that is legally separated from our operating entity (Exchange Strategies Corporation) so that no issue related to liability or financial stress will affect our Client’s ability to complete their exchanges. We can provide, at the Exchanger’s request, additional protection against bankruptcy in the LLC’s operating agreement, including the appointment of an independent Manager for the LLC, if required.
Insurance. Our Errors and Omissions Policy can be downloaded from our public website at any time or viewed by clicking here.

Lastly, on a pragmatic note, potential Exchangers should understand that the temptations and risks associated with delayed exchanges and the accumulation of cash simply do not translate to parked properties. The various provisions described above would make it nearly impossible for even the most devious of Accommodators to liquidate an asset without the Exchanger’s knowledge and ability to intercede. This fundamental difference between delayed and reverse exchanges is key to understanding the differences in asset security.