Segrated Accounts in 1031 Exchange a False Umbrella?

Question

A few 1031 exchange companies use fear to sell their services and boast of segregated accounts for each exchange adding security. Now we find out that still doesn't protect their customer's funds from the Q.I.'s creditors? How can this be?

Answer 1

A longstanding unresolved issue between members of the Federation of Exchange Accommodators (FEA) has been segregated accounts for the proceeds held by Qualified Intermediaries between transactions in a 1031 Exchange.

Most Q.I.’s pool the money in one big account, and do their own sub-accounting for the separated Exchanges. Interest may or may not be credited to the exchange accounts separately through this sub-accounting and the Q.I. is responsible for sending out the 1099’s reporting this interest. Most Q.I.’s retain some percentage of the interest paid, since it’s a relatively painless way to earn enough to keep your doors open, with fees being so competitive.

Some of our fellow FEA members conspicuously insist that the only way to protect the taxpayer’s funds is to open a separate account for each. Perhaps that doesn’t sound like a lot of trouble until you imagine getting over a thousand bank statements a month and trying to reconcile them all with your trust accounting.

These members cited cases where exchange funds were handed over to the debtors of qualified intermediaries, who through foolish or unfortunate circumstances were trying to declare bankruptcy. The reason for so doing cited by the judges in these cases was “commingling of funds.” The judges ruled that since the general funds were commingled with the exchange funds, there was no separation between them, and therefore the debtors in these bankruptcies could claim all. A horrible turn of events to be sure and a dark day for all Q.I.s.

How it passes notice that the commingled funds in question were the Q.I.’s general, operating funds and the taxpayers funds, not the taxpayer’s funds with each other, is beyond understanding. But fear monger marketing and love of beaurocracy are not the subject of this letter. I’ve always been confused about the aforementioned court cases. Since the bankrupt Q.I.s were not knowingly commingling the funds, but had a separate account for their operating expenses that was fed by the fees paid to them at the close of escrow, how could a judge see the commingling of funds?

When the institution holding the proceeds in trust pays interest earned by that account, normally, it is deposited into that account. Since some of it is due to the exchangers and some of it belongs to the Q.I. At that moment, the funds commingle.

Segregating the accounts does nothing to solve this. Those segregated account intermediaries are now commingling their general funds with thousands of segregated accounts, instead of one big one.

As we all know, anyone may be sued, and losing a case is also within the realm of possibilities. No one is immune to life’s vagaries. Can we allow this risk we take to touch the funds of our trusting customers?

The only preventative step is not to allow any interest to hit the account, whether it is one big one, or thousands of smaller ones. There are laws in other industries pertaining to this. For example, the interest earned by security deposits must not go into the account holding said security deposits, since that would be commingling of funds, but are paid directly to the tenant. In our unregulated industry, it is imperative that we do not wait for legislation forcing us to do the right thing to protect our customers’ life savings.

Answer 2

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