WHAT COULD POSSIBLY GO WRONG?
"What could possibly go wrong" should not be the thinking of someone
entering into a Section 1031 exchange! An individual who contemplates a
Section 1031 exchange should question and understand what is going to happen to his or her money during the exchange.
In my opinion, the foremost obligation of the Qualified Intermediary
during a Section 1031 exchange is to protect his clients' funds while
the funds are in the care of the Qualified Intermediary. The client
should fully understand exactly how his funds are to be held and what
protections will be utilized for the protection of those funds. Liquidity of exchange funds is another extremely important consideration.
Strictly Segregated Accounts
The client in a Section 1031 exchange should confirm that the
Qualified Intermediary will establish a separate, segregated account for
his or her exchange. Funds should not be placed in an account that
commingles funds with other exchange clients or the Qualified
Intermediary's operating funds. Is it possible to view the exchange
account online? Ask the Qualified Intermediary about that. It is also
very important to verify language in the Exchange Agreement that
establishes the separation of exchange funds from those of the Qualified
Intermediary or the other clients of the Qualified Intermediary. A
sample clause might read as follows:
"It is the intent of the parties that the money or other property
held in the Exchange Account is to be used solely by the Qualified
Intermediary for its obligations under this Agreement and shall not be
deemed a part of Intermediary's general assets or subject to the claims
of creditors of Intermediary."
Control of Funds
While the rules and regulations of Section 1031 require that the
exchange client not "receive, pledge, borrow or otherwise obtain the
benefits of the money or other property held in the Exchange Account"
during the term of the exchange, there is a simple means by which the
exchange client can avoid an unauthorized disbursement of funds by the
Qualified Intermediary. With the bank's cooperation, a Personal
Identification Number (PIN) can be established and known only to the
bank and the exchange client. The bank would then require the exchange
client to provide the PIN as an authorization for any disbursement of
funds by the Qualified Intermediary.
Security of Funds
The changes to FDIC insurance have made the protection of a client's
funds somewhat easier for the Qualified Intermediary in the past couple
of years, but it is still an important issue. Make sure that exchange
funds will be covered by FDIC insurance up to the limit of $250,000. If
the exchange account will hold more than $250,000, the Qualified
Intermediary may be able to offer full protection regardless of the
amount if the client is willing to forego any interest earnings on the
money during the exchange term. Given the low rate of return on money
market funds currently, it is generally a no-brainer to opt for full
In conclusion, the exchange client should discuss all of the issues
above with his or her Qualified Intermediary and reach a full
understanding of what will be done with the funds during the entire
Section 1031 exchange process.
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