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IRS Clamps Down on Commingled Accounts in
1031 Exchanges
The IRS has just released proposed regulations dealing
with the treatment of interest earned by Qualified Intermediaries
while they hold a client's 1031 exchange proceeds. The
goal of these regulations appear to be designed to curtail
the practice of holding exchange proceeds in commingled
accounts.
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by
Author Gary Gorman
Founding Partner,
The 1031 Exchange Experts |
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In
a 1031 exchange, you can't touch the money from the
sale of your Old Property, and you are required to use
a Qualified Intermediary to hold your money until you
purchase your New Property. There are two ways intermediaries
can hold your exchange proceeds: they can pool all of
their clients' money into a single account (called a
commingled account); or they can put each client's money
in a separate account.
A couple of years ago, there was a ruling in a court
case which said that exchange funds held by the intermediary
in a commingled account were available to any creditor
of the intermediary. But it also said that exchange
funds held in separate, individual accounts were protected
from all creditors. Since that time, I have written
extensively that you must insist that your 1031 exchange
funds be placed in a separate account. Allowing your
intermediary to commingle your funds with others is
flirting with disaster.
Despite the court case, the use of commingled accounts
by intermediaries is very common. Some industry observers
estimate that as many as ninety percent of exchange
funds are held this way. The reason commingled accounts
are so common is because this is a huge source of revenue
for those 1031 intermediaries - they might be earning
4.0% on the commingled account, but paying each client
as little as .5% of this amount. In other words, the
intermediary might earn $4,000 in interest on your money
while it's held in the commingled account, but only
pay you $500.
This
practice is so profitable, in fact, that many intermediaries
charge ridiculously low fees for the exchange ($250,
$350 or $400) just to get the exchange because they
make a killing from your commingled funds. This practice
also encourages the intermediary to make risky investments
with your account in order to maximize their return.
Under the new proposed regulations, the intermediary
would have to issue you a 1099 for the entire $4,000
of interest they earned on your money. Then you would
have to pay tax on this amount. In this case, since
you only received $500 of this interest, the balance
of $3,500, which you did not receive, would be treated
as additional basis in your New Property. This would
then be depreciable over the life of that property (which
might be as long as 39 years). In other words, you would
pay tax on the $3,500 today, and then recover this tax
in small slices over the next 39 years.
The IRS released these as "proposed" regulations in
order to give the public time to comment on them, and
it is expected that the regulations will be finalized
in June of this year. As you can imagine, many intermediaries
are upset by the regulations and a major battle is already
brewing. Because this practice is such a major source
of revenue to most intermediaries, you can expect that
when the regulations become final, which I predict they
will, many intermediaries will go out of business because
they won't have the manpower or systems in place to
manage hundreds, or thousands of accounts, and the cost
of doing a 1031 exchange will go up for everyone. At
the same time, because your money will be in a separate
account, you'll earn a lot more interest on your exchange
funds. And, your exchange funds will be much safer,
because they are in a separate account. This will be
the real benefit of the new regulations.
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