Your Exchange Funds Are Earning Interest. Ask Who Is Keeping It

Between selling one property and buying another, your money sits in an account for weeks or months. On a 2 million dollar exchange running the full 180 days, even a modest rate produces a meaningful sum.

Who receives that interest is not decided by law. It is decided by the exchange agreement you sign, and the answer varies widely between intermediaries.

How much is actually at stake?

On 2 million dollars held for 180 days, each percentage point of annual yield is roughly 10,000 dollars. At 4 percent, the float is about 40,000 dollars.

Most exchanges do not run the full period or involve that much money, but the principle holds. The float is a real number, and on larger transactions it can exceed the intermediary's entire fee several times over.

What are the common arrangements?

The intermediary keeps the interest. Often paired with a lower stated fee. The economics are the same as a higher fee, but less visible.

The exchanger receives the interest. Usually paired with a higher explicit fee. Interest paid to you is generally taxable income in the year received.

A split, or interest above a threshold passed on.

A negotiated rate on larger exchanges, where the intermediary agrees to credit a specified yield.

None of these is improper. What matters is knowing which one applies to you.

Why does it not create constructive receipt problems?

Because the exchange agreement restricts your right to receive the exchange funds themselves during the exchange period. Interest arrangements are structured so they do not give you access to the principal.

Interest actually paid to you during the exchange needs handling carefully so it does not undermine the restrictions. Many agreements pay interest after the exchange concludes for exactly that reason.

Should you negotiate it?

On a small exchange, the amounts rarely justify the conversation. On a larger one, they do.

If you are exchanging several million dollars, ask directly what rate the funds will earn, who receives it, and whether the arrangement can be adjusted. Intermediaries expect the question from sophisticated clients and frequently have flexibility.

Is a high interest offer a good sign?

Not necessarily, and this is the part worth pausing on.

Exchange funds should be held safely. An intermediary offering an unusually high yield may be investing client money in instruments carrying more risk than a straightforward bank deposit. That is precisely how intermediaries have failed in the past.

Safety of principal matters far more than yield. A few thousand dollars of extra interest is not worth any meaningful risk to the entire proceeds of a property sale.

What should you ask about the account?

• ›Is the account segregated to my exchange, or pooled with other clients?
• ›Which bank holds it?
• ›Is it structured as a qualified escrow account or qualified trust?
• ›Does any withdrawal require my written authorisation?
• ›Are funds invested in anything other than bank deposits or short term government instruments?
• ›What is the fidelity bond and errors and omissions cover, and is it per client or aggregate?

The answers matter more than the interest rate, and an intermediary who answers them readily is telling you something useful.

How is the interest taxed?

Interest credited to you is generally ordinary income in the year you receive it, reported separately from the exchange. It is not part of the like kind exchange and does not affect the deferral, although it should be reported.

Interest retained by the intermediary is simply their income and does not appear on your return.

Does the interest affect the exchange itself?

No. Interest is separate from the like kind exchange. It does not reduce the amount you must reinvest, and it does not create boot in itself, provided it is handled under the agreement rather than paid out of exchange principal in a way that gives you access to the proceeds.

What can cause trouble is treating interest casually. Instructing the intermediary to send you interest during the exchange, outside the terms of the agreement, risks blurring the restriction on receiving funds. Most agreements avoid that by paying any interest due after the exchange concludes.

What if the exchange fails?

If the exchange does not complete, the funds and any interest are returned under the terms of the agreement. The gain becomes taxable, potentially in the year the funds are actually received rather than the year of sale, and the interest is ordinary income.

That is one more reason to read the release provisions before signing: they determine when you get your money back and therefore which tax year the gain may fall into.

What to do first

Read the fee and interest provisions of your exchange agreement before signing, and ask the intermediary to state plainly who receives the interest and at what rate. On a large exchange, ask whether the terms are negotiable. Then spend more time on how the funds are held than on what they earn, because the first question protects the principal and the second only affects the margin.

Nothing here is tax, legal or investment advice. 1031Property is not a Qualified Intermediary and does not hold client funds. Confirm arrangements with your intermediary and CPA.