Exchanger Beware...

Intermediary's Commingled Account Destroys Clients' 1031 Exchanges

A group of 1031 investors recently, and tragically, learned they had to pay for a dishonest QI's indiscretion.

The IRS requires that a 1031 investor use an independent third party called a Qualified Intermediary, or "QI," to hold the investor's money during a 1031 exchange. Most QIs put all of their clients' sales proceeds or exchange funds into one single account – a "commingled" account. Very few intermediaries set up separate, "segregated" accounts for each client because it's more expensive and a time-consuming process – and the QI must have a very good working relationship with its bank and strong internal controls. The failure to take this extra security measure can have dire – even criminal – consequences. Having everyone's exchange money in a commingled account can destroy all the exchanges, as the clients of one QI recently discovered.

The intermediary, Nation-Wide Exchange Services, Inc. of St. Paul, Minnesota began day trading with its clients' commingled exchange money. It didn't take long before it lost a substantial amount. Nation-Wide then used incoming exchange funds from new investors to cover requests from existing clients for funds to cover their replacement purchases. This was essentially a Ponzi scheme of sorts: one bad situation covering up an already bad situation.

When the situation finally got to the point where Nation-Wide couldn't cover its exchange requirements, it filed bankruptcy. A court-appointed trustee immediately decided that the single, commingled exchange account was a bankruptcy asset, meaning that the account was available for all creditors! The trustee then concluded that because the account was a bankruptcy asset, all money disbursed from the account during the 90 days before the bankruptcy had to be returned to the account. In other words, those clients that received their funds during that period for the purchase of their new property had to return them to the trustee! Imagine being told that the proceeds you used to buy your new property has to be returned to the courts and handed over to the creditors of the intermediary!

Some clients resisted and a court case ensued. The bankruptcy court ruled in favor of the trustee: the exchange monies held by the intermediary were bankruptcy assets available to general creditors because the intermediary held the money in a commingled account. The court also ruled that because the monies were bankruptcy assets, all disbursements from the account during the prior 90 days must be returned to the account.

The court's reason for ruling with the trustee was that Nation-Wide used a commingled account. It ruled that "the lack of specific client instructions to segregate proceeds, and the Debtor's (Intermediary's) exercise of substantial control over the funds under contractual warrant, mean that the funds became the Debtor's property upon receipt..."

The fact that the QI committed fraud (the principal of the firm ultimately went to jail) against those clients that were caught in this squeeze did not provide the clients any defense against the trustee's claims against their funds.

Nation-Wide 's exchange agreement (i.e., the contractual agreement between it and its clients) provided that the monies it held for each client had to be "Certificates of Deposit, cash management, working capital, Money Market accounts, Bankers Acceptances, or U.S. obligations in [the Debtor's] discretion…" The exchange agreement also provided that Nation-Wide was "not required to maximize the return on these cash proceeds, security and liquidity [were to] take precedence."

On the surface, the exchange agreement made it sound as if Nation-Wide was focused on the security of its client's money. That was, in fact, not the case.

And that is the problem with commingled accounts – you have no guarantees that the QI isn't mishandling your money. This was a fatal mistake that the clients made.

Each client, or exchanger, was responsible for ensuring that a segregated account was established by the intermediary in order to protect their money, as made clear by the court in its ruling when it said:

A trusting exchanger [you, the client] might assume that their sale proceeds would be segregated in some way, and the assumption is not entirely unreasonable. Unfortunately, under the Internal Revenue Code and Internal Revenue Service regulations, the incidents of this aspect of Qualified Intermediaries' operation are unregulated. It literally is a matter of ‘caveat exchanger' [exchanger beware!].

What the court is in effect saying is that if you allow the QI to place your funds in a commingled account, what happens to the money is your own fault.

The court is correct in stating that the qualified intermediary industry is unregulated. With the possible exception of Nevada, which requires that each Intermediary post a bond with the state, anyone can be an intermediary – even a convicted felon.

The 1031 Resolution?

What can you do about it? Be a wise and informed consumer! For example, check with your realtor, CPA, or attorney for referrals and references. Another thing you can do is make sure the QI is bonded. Amazingly, only about 5% of Intermediaries carry a bond.

Most importantly, insist that your escrow funds be held in a segregated account. And even then, check on the account from time-to-time to ensure that the funds are still there (and still in a segregated account) since there is nothing to prevent the QI from moving the funds. Remember, Caveat Exchanger, "...Exchanger Beware!!!"