Protecting Your 1031 Exchange Funds - Segregated Accounts

This is the second part of a series of articles published to inform exchangers how to protect their sales proceeds in a 1031 exchange.

            Many qualified intermediaries combine the funds of all their exchange clients into one account, innocuously dubbed a "pooled account", apparently to avoid the extra work involved with setting up separate accounts for each client or to obtain financial incentives by meeting certain deposit requirements or perhaps for more nefarious purposes. Pooled accounts, more aptly called "commingled accounts", should be avoided by exchangers at all costs.

1.         What is a Commingled Account?

            A commingled account is essentially a single account in the name and taxpayer identification number ("TIN") of the qualified intermediary that contains all of the funds of the intermediary's 1031 exchange clients. A qualified intermediary that commingles the funds of its clients typically uses basic, internal accounting methods to keep track of each client's deposits and withdrawals, while setting itself up as the sole signatory of the commingled account.

2.         What are the risks associated with a Commingled Account?

            Since commingled accounts are in the name and TIN of the intermediary, they are potentially subject to the creditors of the intermediary. In one particularly egregious case, the owner of a Minnesota qualified intermediary doing business as Nation-Wide Exchange Services, Inc., commingled his client's funds and then "invested" them in his less than successful day trading venture. Nation-Wide eventually ended up in bankruptcy.

            Although the commingled exchange funds could easily be traced to the various exchangers (based on settlement statements and wire transfers), the bankruptcy trustee took the position that the commingled account was an asset of Nation-Wide, since it was in the sole name and under the sole control of Nation-Wide (despite the contents of the various exchange agreements between Nation-Wide and its clients that contained language to the contrary). As such, the trustee argued that the commingled account was a bankruptcy asset, available to all the creditors of Nation-Wide. Furthermore, consistent with that position, the trustee also argued (under a bankruptcy "preference" rule), that all funds disbursed from the commingled account during the 90 days before the bankruptcy had to be returned to the account. This put exchangers whose exchanges were finished in the unfortunate position of having to return their exchange funds, which may have already been re-invested in replacement property, to the bankruptcy court.

            Despite the vehement protests of the affected exchangers, the fact that the exchange funds were commingled in one account swayed the Bankruptcy court. The Court held, "the lack of specific client instructions to segregate proceeds, and [Nation-Wide's] exercise of substantial control over the funds under contractual warrant, mean that the funds became the Debtor's property upon receipt..." The Court was not unsympathetic to the plight of the exchangers further holding, "a trusting exchanger might assume that their sale proceeds would be segregated in some way, and the assumption is not entirely unreasonable. Unfortunately, under the Internal Revenue Code and Internal Revenue Service regulations, the incidents of this aspect of Qualified Intermediaries' operation are unregulated. It literally is a matter of ‘caveat exchanger'".

            Based on the foregoing, despite any contractual provisions or intermediary promises to the contrary, the burden is on the exchanger to make sure that its funds are not being held in a commingled account.

3.         What is a Segregated Account?

            A segregated account is an account established (a) in both the name of the qualified intermediary and the exchanger, and (b) under the TIN of the exchanger. The only funds flowing in and out of a segregated account are those of the exchanger. The exchanger should ask the qualified intermediary or the financial institution used by the intermediary, or both, to provide evidence that the account is not commingled.

4.         How does a segregated account provide better protection?

            A segregated account isolates the exchanger's funds from the operating account of the qualified intermediary, and from the other exchange accounts of the intermediary, thereby helping to establish that the accounts are the separate assets of the exchanger and not assets of the intermediary. The lack of the segregation of proceeds in the Nation-Wide case was an important factor in the bankruptcy court's decision to declare the funds as available to creditors. As an added layer of protection, the exchanger should also insist that funds cannot be withdrawn from the segregated account without the signature of both the intermediary and the exchanger. The intermediary's unfettered control over the funds in the Nation-Wide case was another factor impacting the court's decision to declare that the exchange funds were assets of Nation-Wide.