Yet Another 1031 Intermediary Steals Client Exchange Funds

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For the third time this year we have a case where an intermediary has stolen the funds from its client's 1031 exchanges. As in the prior instances of exchange theft, the intermediary was able to commit this fraud because the funds were held in a commingled account.

Intermediaries can hold client exchange accounts in one of two ways: in a commingled account, or in a segregated account.

In a commingled account, the combined proceeds of all of their clients' exchanges are held in one single account. For example, if the intermediary has 200 clients, all of their money would be pooled into one account.

The alternative way is to hold the money in separate accounts for each client. So in this instance, continuing my example from above, the intermediary would have 200 separate accounts -- one for each client.

Recently, a Boston intermediary lost their funds as a result of speculative securities trading. This was made possible because the intermediary, Benistar Property Exchange Trust Company, held clients exchange funds in a commingled account.

This is remarkably similar to the Minnesota case I reported on about six months ago. In the Minnesota case the intermediary suffered massive day trading losses. And just a couple of months ago I reported on a California intermediary who took her clients' exchange funds and disappeared.

The common denominator in each of these cases was the ease in which the intermediary could commit the fraud because the money was held in a commingled account.

By far, the scariest instance was the Minnesota case, because it resulted in a court opinion that said that when an intermediary commingles exchange funds, the commingled account becomes an asset belonging to the intermediary, not the clients!

In the Minnesota case the remaining balance in the commingled account was used to pay other company creditors. In addition, all of the exchange proceeds that had been sent out to complete exchanges in the three months before the intermediary went bankrupt had to be returned by the former exchange clients, and used to pay other creditors.

The reason this is so scary is because we now have a case that specifically states that a commingled exchange account is an asset of the intermediary company (the judge made it very clear that separate exchange accounts belong to the individual exchange clients).

Here's what alarms me about this: suppose an exchange client sues their intermediary and wins a large judgment against them. Because the Minnesota case says that the commingled account is an asset of the intermediary, guess where the client is going to go to collect on their judgment? Exactly! From the commingled account. And what happens to the other clients whose money goes to pay the judgment merely because the intermediary held their money in the commingled account? They sue, and the snowball of lawsuits begins.

Take it one step further: let's say you sue your intermediary. Because your intermediary holds its clients exchange funds in a commingled account, you know that that will be your source of collecting if you win your suit. But to block your ability to collect if you win, all the intermediary has to do is break their commingled account into separate accounts for each client. What are you going to do to keep them from diverting the funds? Right -- when you file your suit you are going to attempt to freeze the commingled account. Can you do this? I don't know -- it probably depends on how good your attorney is.

If the account is frozen, what happens to the intermediary's other clients whose money is trapped in the now frozen account? If the freeze lasts beyond the contract date for the purchase of their new property, they could default on the purchase of their New Property. If it lasts beyond their 180 days their exchange is toast since there are no extensions of the 180 day deadline.

...this is scary because we now have a case that says a commingled account is an asset of the intermediary...

Really scary stuff isn't it? The solution, again, is to make sure that your exchange funds are held in a separate exchange account: just your funds in one account and no one else's. And a separate account must be separate not only from other client's monies, but also separate from the intermediary's assets.

My company, for example, holds the funds from every client's exchange in its own separate account because it's obviously the only way to protect our client's funds. Each of our accounts has the clients name on it (i.e., “The 1031 Exchange Experts, as intermediary for Fred and Sue Jones”), AND the client's tax identification number or social security number is also on the account. If something bad happens to us, the Qualified Intermediary, then our client's exchange funds are still intact and accessible.

Another way we give our clients assurance that their money goes into their own account (and stays there) is with a service we call 1031Access (sm), which assigns a secure portal through our web site to each client for their exchange. By using their assigned username, this 'secret' portal allows them to view their money in their account at the bank, 24/7, via a secure Internet connection. Their portal is protected with a password they set themselves. In this way, using their secret portal, clients can see what moneys have come into their account, what's gone out, how much interest the account has earned and what their current interest rate is.

Like the judge in the Minnesota fraud case said, if your exchange money is in a commingled account, “Caveat Exchanger” (or, “Exchanger Beware!”).

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