"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 FDIC insurance.
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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