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How Secure are Your Exchange Funds?
Guidelines provided by the IRS clearly state that exchangers may not have access to the funds generated from the sale of a property being sold via IRS code 1031. This rule created the need for a Qualified Intermediary (QI).
A QI functions mainly to hold and take responsibility for exchange funds until a replacement property is found. The QI then provides the exchange funds to the seller of the replacement property. It is important that the exchanger never take constructive or actual receipt (control) of the money.
Qualified Intermediaries are not regulated. When interviewing potential QIs to handle a transaction, exchangers should evaluate not only the overall integrity of the QI (years in business, professional affiliations with organizations such as FEA are good starting points) , but also the adequacy of the security protecting exchange funds while under control of the QI.
Most Qualified Intermediaries are in control of millions of dollars at any one time; how and where those funds are held must be very clear and stated in writing.
Funds can be held in two ways, commingled or segregated.
They are “commingled” when pooled into one account with all other funds held by the QI. Case law indicates commingled funds are an asset of the QI and subject to any legal action taken against that company, effectively subordinating exchangers’ rights to their own funds, to creditors of the QI’s. If a QI goes bankrupt or is sued, the exchanger could lose it funds to payment of other obligations of the QI.
A “segregated” account is one set up for each individual exchanger. On this point, case law shows that a segregated account, if set up properly, is considered separate property of the exchanger, minimizing exposure to loss or fraud committed by the QI..
Where the funds are held is also of great concern. If in a bank, be aware that the FDIC only insures each account up to $100,000. Security for funds being held by the QI generally comes in the form of a fidelity bond and/or an insurance policy . The combined amount of the bond and the insurance policy may or may not be equal to the aggregate amount of money being held by the QI for all exchangers’ funds. This point should be carefully discussed with the QI.
If the funds will be invested during the holding period, details must be provided on the type of investments considered and who benefits from the proceeds. Requiring notarized authorization from the exchanger to move or disburse the funds is a good way to stay informed and prevent misuse of the funds.
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