EXCHANGER BEWARE! Commingled accounts...

"Exchanger Beware...!"

The Perils of Commingled
Exchange Accounts

Section 1031 of the IRC allows you to defer the capital gains tax upon the sale of qualified real estate and/or personal property used for business, but one of the requirements of doing an exchange is that the exchanger/investor must use a Qualified Intermediary or QI. So, how do you find a good QI...?

After a recent court case (91 AFTR 2d 2003-1850) there is now an obvious criteria. Most QIs place their clients' money in a commingled, escrow-type account. This can be disastrous: if something goes awry with the QI's company, your exchange could fail and your money will be at serious risk. In the case cited above, the QI was day-trading with their clients' exchange proceeds, and they eventually had to file for bankruptcy.

The courts ruled that because the exchange proceeds were in a commingled account, they were a "bankruptcy asset" – and available for the creditors of the bankruptcy proceedings. So all of the clients' proceeds were used to satisfy the creditors – including those clients who had already taken their money out within the last 90 days to purchase their replacement property! They had to give their money back to the courts and creditors!

The 1031 Solution: make sure the Intermediary uses separate or segregated accounts for their clients' proceeds.

Something else to note: the QI industry is unregulated. So what can you do to protect your money during the exchange? Be a wise and informed consumer: get referrals or references about an Intermediary from real estate professionals, such as Realtors, accountants, attorneys, etc. Secondly, make sure your QI is both bonded and insured.

And most importantly, insist that your escrowed funds be held in a separate or segregated account. Remember, in the words of that bankruptcy court, "...caveat exchanger!" or Exchanger Beware!

--The Experts

Read a more detailed account of this situation in "1031Solutions" in the February 18, 2004 edition of The Colorado Real Estate Journal by Gary Gorman.