How Exchange Funds Are Protected (and How They Have Been Lost)

Between the day your relinquished property closes and the day you take title to the replacement, the sale proceeds sit with a qualified intermediary. The federal tax rules say almost nothing about how that money must be held. That gap is where client funds disappeared in 2007 and 2008, and it is why the bonding, escrow and state-licensing safeguards exist today. Here is what the rules require, what they leave to the contract, and what to ask before you wire anything.

The regulation keeps you away from the money, but does not guard it

The qualified intermediary safe harbor in Reg. section 1.1031(k)-1(g)(4) lets a third party acquire and transfer both properties under a written exchange agreement. Paragraph (g)(6) adds the condition that matters here: the agreement must provide that you have no right to “receive, pledge, borrow, or otherwise obtain the benefits” of the money before the exchange period ends. That restriction keeps you out of constructive receipt. It does nothing for the safety of the funds.

Nothing in the regulation says how the intermediary holds the money or what happens if it fails. The Fourth Circuit said so in 2011: the Code and regulations “contain no requirement or restriction as to how the QI company is to hold the proceeds,” and how the money is invested “typically is governed by the agreement between the exchanger and the QI company” (United States v. Okun, No. 09-4743).

The regulation does offer a second safe harbor. Under paragraph (g)(3), a qualified escrow account or qualified trust is one whose holder is not you or a disqualified person, and whose agreement expressly limits your rights to the funds. An intermediary that places your money in such a bank account, with two-signature withdrawals, uses both safe harbors at once; several states later wrote that combination into law.

2007: a fraud

Per the Fourth Circuit’s opinion, in 2005 an individual formed a holding company and began buying qualified intermediary companies. Money held by those companies for exchangers was used “for personal use and for purposes related to” the owner’s real estate business, without disclosure and in violation of the exchange agreements. The group filed for bankruptcy in May 2007. The court put the loss to exchangers at “in excess of $125 million.” After a jury trial on twenty-three counts the owner was sentenced to 1,200 months, and the Fourth Circuit affirmed on November 17, 2011.

The U.S. Attorney’s release the same day described roughly $126 million used to “support his lavish lifestyle, pay operating expenses for his various companies, invest in commercial real estate, and purchase additional qualified intermediary companies.” The IRS had already reacted in February 2008. Fact Sheet FS-2008-18 warns: “Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations.”

2008: an insolvency inside a large company

The second loss was not theft. A Form 8-K filed December 1, 2008 reports that on November 26, 2008 a title-insurance holding company “and its wholly owned subsidiary” exchange company “filed voluntary petitions for relief under Chapter 11” in the Eastern District of Virginia, which put $473.5 million of the parent’s debt into default. Exchangers with money at the subsidiary were caught inside that proceeding.

The clause that protects your tax position, the one saying you have no rights to the money, also defines your position if the intermediary fails. Rev. Proc. 2010-14 puts it plainly: once the intermediary is in bankruptcy or receivership, the taxpayer “generally may not seek to enforce its rights under the exchange agreement with the QI or otherwise access the sale proceeds” outside the proceeding while it is pending.

What the IRS did for victims

Rev. Proc. 2010-14 is the reporting safe harbor for a failed exchange caused by a defaulting intermediary. You qualify if you transferred the relinquished property to a qualified intermediary under the (g)(4) safe harbor, identified replacement property within 45 days (unless the default came first), failed solely because the intermediary defaulted and entered bankruptcy or receivership, and never had actual or constructive receipt of the proceeds.

If you qualify, you do not report the gain in the year of sale. You report it as payments arrive, under a gross profit ratio method, and payments count whether they come from the intermediary, its bankruptcy estate, or “the QI’s insurer or bonding company.” If the recovery ends up below your basis, section 165 allows a loss. The Form 8824 instructions point to this procedure.

A hypothetical shows the effect. You sold for $1,000,000 with an adjusted basis of $400,000, and the intermediary failed after you identified. In the first year a payment arrives, a court order fixes your recovery at $700,000. Under the procedure the selling price becomes $700,000, the gross profit $300,000 and the contract price $700,000. The $700,000 payment produces $300,000 of recognized gain in the year received, instead of $600,000 of gain in the year of the sale. The $300,000 the estate never paid is not deducted; it is simply never taxed. Run your own numbers with your CPA.

The safeguards that followed

Two state statutes show the pattern. California Financial Code section 51003 requires an exchange facilitator either to maintain a fidelity bond “in an amount not less than one million dollars” (or deposit that amount in cash, securities or letters of credit), or to deposit all exchange funds in a qualified escrow account or qualified trust where withdrawals require the facilitator’s and the client’s written authorization.

Washington’s RCW 19.310.040 offers the same two choices; its escrow option requires both the facilitator and the client to authenticate withdrawals and gives the client access to bank statements. RCW 19.310.080 adds a prudent investor standard, requires funds to be held “in a manner that provides liquidity and preserves both principal and any earned interest,” bars commingling with the facilitator’s operating accounts, and states that exchange funds “are not subject to execution or attachment on any claim against the exchange facilitator.”

Where no statute applies, the exchange agreement and the account structure are the only protection, and the questions below, drawn from the statutes, apply in any state. Our page on choosing a qualified intermediary goes deeper, and protecting an exchange from fraud and errors covers the rest of the transaction.

What to do now

1. Ask where the money will sit. You want a segregated qualified escrow or qualified trust account at a bank, with withdrawals requiring your authorization as well as the intermediary’s, and statements you can see.
2. Ask what stands behind the intermediary: the fidelity bond amount and insurer, and whether the account structure would satisfy a state facilitator statute.
3. Read the failure clause of the exchange agreement before signing, and ask who earns the interest while the funds are parked.
4. Keep the exchange agreement and identification notice; if an intermediary ever defaults, they and Rev. Proc. 2010-14 govern how you report. Start your exchange plan with the account question settled.

Sources

• Reg. section 1.1031(k)-1, Treatment of deferred exchanges
• IRS, Rev. Proc. 2010-14
• IRS, Fact Sheet FS-2008-18, Like-Kind Exchanges Under IRC Code Section 1031 (February 2008)
• IRS, Instructions for Form 8824
• U.S. Court of Appeals for the Fourth Circuit, United States v. Okun, No. 09-4743 (November 17, 2011)
• U.S. Attorney’s Office, Eastern District of Virginia, press release of November 17, 2011
• SEC EDGAR, Form 8-K filed December 1, 2008 (Item 1.03)
• California Financial Code section 51003
• RCW 19.310.040, Duties of exchange facilitator, fidelity bonds
• RCW 19.310.080, Exchange funds, prudent investor standard