Protecting Your Exchange Funds: Segregated Accounts, Qualified Escrow and Qualified Trusts

For up to 180 days, the proceeds of your property sale sit in an account controlled by someone else. That is the nature of a 1031 exchange. You cannot hold the money yourself without ending the exchange, so a Qualified Intermediary holds it for you.

The uncomfortable fact is that intermediaries are not banks. There is no federal regulator, no deposit insurance on exchange funds as such, and in most states little oversight. Intermediaries have failed, and when they did, how funds were held largely determined what clients recovered.

This article focuses on the practical protections available to you.

Why can intermediary failures happen?

Most failures have involved some combination of commingled funds, investment of client money in risky assets, fraud, or financial difficulty at a parent company. When client funds are held together in a pooled account in the intermediary's name, clients can end up as general creditors if the intermediary becomes insolvent.

What protections do the regulations allow?

The Treasury regulations provide safe harbours that let exchange funds be held in arrangements that protect them while still preventing you from having access to the money.

Qualified escrow account. Funds are held by an escrow holder who is not you or a disqualified person, under an agreement that restricts your access to the funds in line with the exchange rules.

Qualified trust. Funds are held by a trustee who is not you or a disqualified person, again under an agreement limiting your rights to receive the money.

These arrangements can be combined with a Qualified Intermediary. The key point is that the money can be held in a structure separate from the intermediary's general assets.

What is a segregated account?

An account holding only your exchange funds, identified to your exchange, rather than a pooled account holding many clients' money. Segregated accounts do not remove all risk, but they make it far easier to identify and recover your funds if something goes wrong.

Many intermediaries offer segregated accounts on request, sometimes for a small fee or with different interest arrangements.

What is dual signature control?

An arrangement requiring your written authorisation, in addition to the intermediary's, before funds can be moved. It must be structured carefully so you do not have the right to receive the funds yourself, which would be constructive receipt. Properly drafted, it prevents the intermediary from moving money without your knowledge.

What should you ask for in writing?

• ›A segregated account in your name or identified to your exchange
• ›The name of the bank holding the funds
• ›Whether funds are held in a qualified escrow account or qualified trust
• ›Whether withdrawals require your written authorisation
• ›The amount of fidelity bond and errors and omissions insurance, and whether it is per client or aggregate
• ›Whether funds are invested, and if so in what
• ›Who receives the interest earned

What do state laws require?

A small number of states impose requirements on exchange accommodators, such as bonding, insurance or holding funds in certain types of accounts. Most states impose little or nothing. Do not assume that an intermediary is regulated simply because it operates in your state.

Is a larger intermediary always safer?

Size and longevity help, as do affiliations with established financial institutions. But the structure of how your money is held matters more than the size of the firm. A small intermediary using segregated qualified escrow accounts may present less risk to your funds than a large one pooling client money.

What should make you walk away?

• ›Refusal to provide segregated accounts
• ›Vague answers about where funds are held
• ›High interest promises on exchange funds, which may indicate risky investment
• ›Pressure to sign quickly without reading the agreement
• ›Inability to provide evidence of bonding or insurance

What happens to interest earned on exchange funds?

Exchange funds held for weeks or months can earn interest, and practices vary. Some intermediaries keep the interest as part of their compensation. Others pass it to the exchanger. Interest paid to you is generally taxable income and, if paid out during the exchange, must be handled so it does not create constructive receipt problems.

The amount is rarely large enough to drive the choice of intermediary, but how it is handled should be disclosed in the agreement. Unusually high interest rates offered on exchange funds deserve caution, because they may indicate that funds are being invested in riskier assets.

What to do first

Before your sale closes, ask your intermediary to confirm in writing how your funds will be held, where, and who can move them. Choose segregated qualified escrow or qualified trust arrangements where available, and read the exchange agreement before signing. The few hours this takes protect what may be the largest sum of money you ever hand to anyone.

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