Exchange Fund Interest: Who Earns It and Who Decides

The Interest Question Most Clients Don't Think to Ask

When a relinquished property closes and the proceeds transfer to a qualified intermediary, most exchangors are focused on the clock — 45 days to identify, 180 days to close. What they rarely think about in that moment is a quieter question: what happens to the interest those funds earn while they sit?

It's a question that matters more than it looks. Depending on the size of the exchange, even a short hold period at current rates can produce meaningful interest income. And the answer touches on tax treatment, QI fiduciary positioning, regulatory requirements in some states, and — critically — how the exchange agreement is drafted. Getting it wrong creates surprises for clients, potential audit exposure, and real liability risk for the QI.

What the IRS Actually Says About Exchange Fund Interest

Section 1031 of the Internal Revenue Code and the Treasury Regulations at §1.1031(k)-1 are surprisingly quiet on the specific mechanics of how exchange funds should be held. What the regulations do make clear is that the exchangor cannot have actual or constructive receipt of the exchange proceeds during the exchange period — because that would collapse the exchange entirely and trigger immediate recognition of gain.

This constructive receipt rule is the foundation of every fund-holding decision a QI makes. If the exchangor can unilaterally draw on the funds, direct how they're invested, or access the interest at will, the IRS may treat that as constructive receipt regardless of what the exchange agreement says.

On interest specifically, the IRS has addressed this through Revenue Procedure 2010-14 and related guidance. The consistent position: interest or growth earned on exchange funds is not treated as like-kind property. It does not qualify for tax deferral under Section 1031. Instead, it is taxable to the exchangor as ordinary income in the year it is received — or constructively received.

That one fact has significant downstream consequences for how QIs structure accounts and draft agreements.

Segregated Accounts: The Operational Standard and Why It Matters

Most experienced QIs already know that commingling exchange funds with operating accounts is a serious professional and legal risk. But the rationale goes deeper than just regulatory tidiness.

Holding each client's exchange proceeds in a dedicated, segregated account accomplishes several things simultaneously:

• Insolvency protection: If a QI faces financial distress, segregated funds are less likely to be treated as general assets of the company — a lesson the industry learned painfully from high-profile QI failures in the mid-2000s.
• Accurate interest attribution: Segregated accounts make it unambiguous whose funds earned what. Commingled accounts create allocation disputes and potential tax reporting errors.
• Audit defensibility: A clean paper trail from closing through reinvestment is essential if the exchange is ever scrutinized. Segregated accounts with dedicated statements provide that trail automatically.
• State regulatory compliance: Several states — including California, Nevada, Oregon, and Washington — have enacted QI regulations that explicitly require segregation of exchange funds. QIs operating across state lines must know which rules apply to which transaction.

The account structure question isn't just operational housekeeping. It's a substantive part of how a QI protects the exchange and, by extension, the client.

Drafting the Exchange Agreement: Who Gets the Interest and When

Because interest earned on exchange funds is taxable income to the exchangor — not like-kind property — the exchange agreement needs to address it clearly. This is where many QIs leave ambiguity that causes problems later.

There are two common approaches in practice:

1. Interest passed through to the exchangor: The agreement specifies that all interest earned on the segregated account will be delivered to the exchangor at exchange completion (or upon disbursement of any remaining exchange funds). The exchangor then reports that interest as ordinary income. This is the most transparent approach and is generally preferred by advisors who want clean reporting.
2. Interest retained by the QI as compensation: Some QIs, particularly those charging lower transactional fees, retain the interest earned on exchange funds as part of their compensation model. This must be disclosed clearly in the agreement. If it isn't, it creates a conflict of interest that can undermine the QI's positioning as a neutral intermediary.

Either model is defensible — but only if the agreement reflects the actual arrangement and the client has acknowledged it. Wealth advisors working with QI partners should review this provision carefully in every engagement letter. It affects both the client's tax position and the QI's economic model.

A related issue: some QIs sweep exchange funds into money market vehicles or short-duration instruments to generate yield during the hold period. This is generally permissible, but the QI should ensure that the exchangor has no control or direction over those investment decisions — again, to avoid constructive receipt. The investment choice should belong to the QI, documented as such, not offered as a menu for the client to select from.

Practical Guidance for QIs and Their Advisor Partners

The combination of proper account segregation, clear interest treatment, and a well-drafted exchange agreement is not complicated — but it requires intention. Here's what sound practice looks like:

• Open a dedicated account for each exchange at closing, before funds arrive.
• Document the account structure and the QI's investment authority in the exchange agreement.
• State explicitly whether interest is passed to the exchangor or retained by the QI, and ensure the client acknowledges that provision.
• Issue accurate 1099-INT reporting for any interest paid to exchangors — do not omit this step even when amounts seem small.
• Maintain complete account statements for each exchange as part of the permanent exchange file.
• For multi-state transactions, verify which state's QI regulations govern the fund-holding obligations.

Wealth advisors and family office professionals should treat these questions as due diligence items when evaluating QI partners. A QI that can't explain its account structure and interest policy clearly is a QI that warrants closer scrutiny.

The mechanics of how exchange funds are held may not be the headline issue in a 1031 transaction — but they are the kind of detail that distinguishes a well-run exchange from a defensible one.

Disclaimer: This article is provided for informational and educational purposes only and does not constitute legal, tax, or financial advice. Readers should consult a qualified attorney or tax professional regarding their specific circumstances before undertaking a 1031 exchange.