Having worked in the 1031 Exchange arena for many years now, I am often asked by potential customers how do I protect myself from loss of my funds while you are holding them as the Qualified Intermediary.

For many years our industry has touted the fact that "We carry a Fidelity Bond" as a protection to our customers.  With the down-turn in the real estate industry there have been many Qualified Intermediaries that have lost the principal amounts which were entrusted to them by an Investor during the participation of a 1031 Exchange.  One very large Qualified Intermediary (affiliated with the 3rd largest title company at the time - 2008) found that the funds of their investor client were illiquid due to the investment vehicle they used (Auction Rate Securities).  When in operation this Qualified Intermediary would often advertise that they held a very large Fidelity Bond which would cover the client should a loss occur.  Unfortunately, as many investors have come to find out, the Fidelity Bond may not have. 

So what does a Fidelity Bond cover:

Well the primary coverage of a Fidelity Bond is to protect the holder (an employer) of employee theft. The bond will pay for loss or damage to money, securities and other property directly from theft or forgery by an employee.

You might ask yourself so how does that help me (the consumer), well generally speaking it does not.  The party that can draw upon a Fidelity Bond is the actual holder of the bond not the general public or someone who has been harmed by the company. 

Next time you encounter someone who is touting that your transaction will be covered by a Fidelity Bond ask to see where in the bond it declares that it can be drawn upon by a third party?  Ask if you can be added as a loss payee.

Generally they will be unable to supply you with this and as a result here are some other ways that you can protect yourself when you engage a Qualified Intermediary (QI):

Ask your QI if they utilized both the QI safe harbor AND Qualified Escrows safe harbor of the Internal Revenue Code Section 1031.  With a Qualified Escrow an escrow is established with the bank (the bank that is holding the exchange funds during the exchange) in which the bank agrees that they will not release the funds to the QI without the express written consent of the client (you the taxpayer doing the exchange). 

Also review the QI agreement and be certain that it stipulates that the Exchange funds will never be placed in the QI's general operating fund and that all clients funds are held in segregated FDIC Insured Money Market Accounts.  Ask the QI how they invest the funds -- there should be no exotic investments made with the clients monies (e.g. Auction Rate Securities, Stocks, Real Estate etc). 

Each Investor client should be there own advocate and ask questions.  Your Intermediary should have no issues with your questions and should be able to produce any document you are requesting.  Protect yourself by establishing that your funds will be protected by a Qualified Escrow during your 1031 Exchange transaction. 

In the end, the goal is to preserve your principal and to defer your capital gains allowing you the Investor the maximum benefit of your 1031 Exchange.  You and your monies should be priority number 1.