A group of 1031 investors recently, and tragically, learned they had to pay for a dishonest QI's indiscretion.

The IRS requires that a 1031 investor use an independent third party called a Qualified Intermediary, or "QI," to hold the investor's money during a 1031 exchange. Most QIs put all of their clients' sales proceeds or exchange funds into one single account – a "commingled" account. Very few intermediaries set up separate, "segregated" accounts for each client because it's more expensive and a time-consuming process – and the QI must have a very good working relationship with its bank and strong internal controls. The failure to take this extra security measure can have dire – even criminal – consequences. Having everyone's exchange money in a commingled account can destroy all the exchanges, as the clients of one QI recently discovered.

by Gary Gorman Founding Partner, The 1031 Exchange Experts

The intermediary, Nation-Wide Exchange Services, Inc. of St. Paul, Minnesota began day trading with its clients' commingled exchange money. It didn't take long before it lost a substantial amount. Nation-Wide then used incoming exchange funds from new investors to cover requests from existing clients for funds to cover their replacement purchases. This was essentially a Ponzi scheme of sorts: one bad situation covering up an already bad situation.

When the situation finally got to the point where Nation-Wide couldn't cover its exchange requirements, it filed bankruptcy. A court-appointed trustee immediately decided that the single, commingled exchange account was a bankruptcy asset, meaning that the account was available for all creditors! The trustee then concluded that because the account was a bankruptcy asset, all money disbursed from the account during the 90 days before the bankruptcy had to be returned to the account. In other words, those clients that received their funds during that period for the purchase of their new property had to return them to the trustee! Imagine being told that the proceeds you used to buy your new property has to be returned to the courts and handed over to the creditors of the intermediary!

Some clients resisted and a court case ensued. The bankruptcy court ruled in favor of the trustee: the exchange monies held by the intermediary were bankruptcy assets available to general creditors because the intermediary held the money in a commingled account. The court also ruled that because the monies were bankruptcy assets, all disbursements from the account during the prior 90 days must be returned to the account.

The court's reason for ruling with the trustee was that Nation-Wide used a commingled account. It ruled that "the lack of specific client instructions to segregate proceeds, and the Debtor's (Intermediary's) exercise of substantial control over the funds under contractual warrant, mean that the funds became the Debtor's property upon receipt..."