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Security of Funds
One of the Biggest Issues Facing 1031 Exchanges
Security is the big issue for those
investors doing 1031 exchanges. There have been a lot
of stories in the news lately about intermediaries
who’ve taken their clients’ exchange funds. All of
the bad things that happen with exchange accounts stem
from commingled accounts, rather than separate exchange
accounts. Yet few intermediaries place each exchange
client’s money in a separate account for them; commingling
is the industry standard.
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by Gary Gorman
for Citywide Exchange Services |
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When “commingling,” all of the exchange funds are placed in a single account
rather than in a series of multiple, or “separate,” accounts set up for each
client. The primary reason that intermediaries commingle is to maximize their
personal return on your money – they earn a large return and pay you a small
portion of it. With a separate account you get all the earnings from the account.
As I said, all bad things start from a commingled account. For example, in an
effort to maximize their return, the intermediary might make risky investments
with a commingled account. With a separate account your money is typically in
a money market account for you and you get those earnings. With a commingled
account it is much easier to steal the entire account. It would be very difficult,
if not impossible, to steal hundreds of individual accounts; doing so would take
a lot of time, and it couldn’t be done without the bank noticing.
With separate accounts you could require
dual signatures—yours, and the intermediary’s—for
each withdrawal. This isn’t possible with a commingled account, although the
intermediary could set up “sub-accounts” of the commingled account and use a
dual signature feature for “your” sub-account.
Sub-accounts are simply an accounting of the master account, and don’t protect
you because the risk is at the master account level, which the intermediary controls,
and the intermediary could draw the master account down below the balance of
the sub-accounts. For example, the sub-accounts might all add up to $10 million
on paper, but the intermediary might have drawn the master account down to $500.
A dual signature arrangement on a sub-account is an arrangement just between
you and the intermediary since the bank is only bound by the signature agreement
for the master account.
So, how do you know if you have a truly separate account or just a sub-account?
The easiest way is to verify whose tax identification number (or social security
number) is on the account. If it’s yours, it’s a separate account; if it’s the
intermediary’s then it’s
a sub-account.
How do you protect yourself? The most important thing is to make sure that your
exchange money is in a truly separate account. Then make sure that your account
requires dual signatures to withdraw money. There should be a form that sets
out the signatures required to access the account. You should have a copy of
this form in your files, and the form should be signed by an officer of the bank
proving that the bank is aware of the dual signature arrangement and agrees to
be bound by it.
Or you could have your bank handle
your exchange – the problem
is that very few banks will act as a qualified intermediary.
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