Where's Your Commingled Exchange Account Invested?

Interest rates on separate exchange accounts are currently in the toilet. So it’s not surprising that taxpayers who are doing 1031 exchanges are intrigued with Qualified Intermediaries that offer a high rate of interest on their exchange accounts. But how are they earning those rates? If you use them to do your exchange, what will they be investing your money in? Will you even know where your money is?

Most intermediaries commingle their client’s money. By commingle, I mean the pooling of all the clients’ exchange funds into one account. The benefit of pooled accounts is that the intermediary is investing a larger amount of money, and is therefore able to obtain a greater return. Just look in the business section of your Sunday paper: you’ll notice the difference in interest rates on $1,000 invested in a money market account versus $1 million invested in a CD.

...A 1031 exchange is a relatively short-term event, but losing your money could be forever...

Of course the intermediary is going to keep some of the interest, which is the whole point of pooling to begin with. In fact, the more the account earns, the bigger the spread—the amount they keep. The intermediary’s spread is influenced by two factors; one: the balance in the account, and two: the interest rate the account earns. For example, if the intermediary agrees to pay you two percent while the account earns three percent, he makes a spread of one percent. But if he can invest the account to earn five percent and still only pays you two percent, his spread increases to three percent.

The very real and obvious incentive is for the intermediary to maximize the amount of spread the pooled account earns. Again, this is done with the balance in the account, and by the manner in which the account is invested. Intermediaries have some control over the balance in the account. One common way of manipulating the balance is by how their client’s exchange agreements are written. For example, if you are unable to acquire any of the properties you designate, or if you acquire your properties, but don’t spend all of the proceeds, their agreement may stipulate that your proceeds remain locked in the account and will not be returned to you until the expiration of the 180-day exchange period. Alternatively, the exchange agreement could be written to allow disbursements to you in these situations. Typically intermediaries that pool are going to lock up your funds for the entire 180 days

The amount of spread the intermediary can earn is also something they can control. Obviously, they try to maximize their spread by what the money is invested in. And as we all know: the greater the yield, the greater the risk. Now, don’t get me wrong; I am not saying these intermediaries go too far out on a limb on purpose, or that they even think or know there is any risk in what they are doing. Yet there may very well be greater problems in their investments than even they know about. And if they DO know, they certainly aren’t going to tell you.

Let’s assume that the entire account is invested in a so-called money market account. I say so-called because there are different types of money market accounts (How many of you knew that?). So what the intermediary thinks is a true money market account may be, in fact, something entirely different. The SEC limits the investments of a true money market account to short-term instruments that mature in less than 13 months, with the average maturity of the fund less than 90 days.

But then there are enhanced money market funds which are allowed to invest in other types of securities in order to ‘enhance’ their return. Some typical examples of enhancements are asset-based commercial paper (or AB CP). Asset based means investments that may very well hold sub-prime loans and could be worth pennies on the dollar. Another common investment in an enhanced money market fund is structured investment vehicles, or SIVs: entities that issue commercial paper. Currently they’re having trouble selling new paper, which brings into question their ability to pay off their outstanding paper. What happens to the outstanding paper held by an enhanced money market account if the entity can’t pay it off? It means your exchange proceeds have just vaporized—even though they were invested in a money market fund.

So what intermediary would be so foolish as to use enhanced money market funds? Unfortunately, many have indeed invested their clients’ exchange proceeds with such “safe” big-company names as Legg Mason, Sun Trust, Wachovia, Bank of America, Northern Trust and the Janus Funds—all of which have recently had to put money into their money market funds to keep them solvent (even though they are not legally required to do so).

Not all of the big names have stepped up with their own funds to take care of the problem. The Community Bankers Mutual Fund money market account and General Electric’s Asset Management account both closed and paid investors only 96 cents on the dollar. The State of Florida, which operates an enhanced money market account for those communities which have excess property tax funds to invest, recently suspended withdrawals completely. It didn’t have enough liquid cash because of problems with the enhancements in their fund.

Wait, it gets worse. There is also an investment vehicle called auction rate securities (or ARSs) which are long-term maturity vehicles, typically real estate-backed, that until recently had auctions where the interest rates were adjusted weekly. These auctions have ceased, leaving $330 billion (with a B!) of these securities unmarketable. Prior to the halt of the auction, ARSs were marketed as essentially the same as cash. Now they’re worthless. What happens if your money market account holds a lot of ARSs?

Interestingly, one of the most common responses many of the intermediaries offer when asked about possible problems with a pooled account is, “we’re too big to have problems with our account.” Oh really? Bigger than General Electric? Bigger than the State of Florida? Or bigger than Enron, WorldCom, Bear Stearns or Countrywide?

I’m not making this stuff up! You have access to the internet—just Google, “auction rate securities,” “structured investment vehicle,” or “enhanced money market fund” and see for yourself. So this brings me back to the most important question, the one I’ve been banging the drum on for years, and that is: Do you really know where your money is? What if your exchange account is only worth 96 cents on the dollar? What if the account is frozen and you can’t get the money out? What if money market accounts are the next big sub-prime mortgage mess. An exchange is a relatively short-term event, but losing your money could be forever. The only truly safe exchange account is a separate bank account that contains only your money – not commingled in an enhanced money market account. It may not pay as much, but at least it will be there when you need it.