IRS Clamps Down on Commingled Accounts in 1031 Exchanges

The IRS has just released proposed regulations dealing with the treatment of interest earned by Qualified Intermediaries while they hold a client's 1031 exchange proceeds. The goal of these regulations appear to be designed to curtail the practice of holding exchange proceeds in commingled accounts.

In a 1031 exchange, you can't touch the money from the sale of your Old Property, and you are required to use a Qualified Intermediary to hold your money until you purchase your New Property. There are two ways intermediaries can hold your exchange proceeds: they can pool all of their clients' money into a single account (called a commingled account); or they can put each client's money in a separate account.

A couple of years ago, there was a ruling in a court case which said that exchange funds held by the intermediary in a commingled account were available to any creditor of the intermediary. But it also said that exchange funds held in separate, individual accounts were protected from all creditors. Since that time, I have written extensively that you must insist that your 1031 exchange funds be placed in a separate account. Allowing your intermediary to commingle your funds with others is flirting with disaster.

Despite the court case, the use of commingled accounts by intermediaries is very common. Some industry observers estimate that as many as ninety percent of exchange funds are held this way. The reason commingled accounts are so common is because this is a huge source of revenue for those 1031 intermediaries - they might be earning 4.0% on the commingled account, but paying each client as little as .5% of this amount. In other words, the intermediary might earn $4,000 in interest on your money while it's held in the commingled account, but only pay you $500.

...commingling is so profitable, many QIs charge ridiculously low fees ($250, $350 or $400) because they make a killing from your our funds...

This practice is so profitable, in fact, that many intermediaries charge ridiculously low fees for the exchange ($250, $350 or $400) just to get the exchange because they make a killing from your commingled funds. This practice also encourages the intermediary to make risky investments with your account in order to maximize their return.

Under the new proposed regulations, the intermediary would have to issue you a 1099 for the entire $4,000 of interest they earned on your money. Then you would have to pay tax on this amount. In this case, since you only received $500 of this interest, the balance of $3,500, which you did not receive, would be treated as additional basis in your New Property. This would then be depreciable over the life of that property (which might be as long as 39 years). In other words, you would pay tax on the $3,500 today, and then recover this tax in small slices over the next 39 years.

The IRS released these as "proposed" regulations in order to give the public time to comment on them, and it is expected that the regulations will be finalized in June of this year. As you can imagine, many intermediaries are upset by the regulations and a major battle is already brewing. Because this practice is such a major source of revenue to most intermediaries, you can expect that when the regulations become final, which I predict they will, many intermediaries will go out of business because they won't have the manpower or systems in place to manage hundreds, or thousands of accounts, and the cost of doing a 1031 exchange will go up for everyone. At the same time, because your money will be in a separate account, you'll earn a lot more interest on your exchange funds. And, your exchange funds will be much safer, because they are in a separate account. This will be the real benefit of the new regulations.