QI Fund Custody: Escrow, Accounts and Interest Done Right

The Custody Question Nobody Asks Until It's Too Late

When a relinquished property closes, the net proceeds don't simply sit in limbo. They move—fast—into the hands of a qualified intermediary (QI), and from that moment forward, the way those funds are held, titled, and managed carries real legal weight. Yet in practice, fund custody is often treated as an administrative afterthought rather than a compliance priority.

That's a mistake. The IRS is explicit that an exchanger must not have actual or constructive receipt of exchange proceeds during the exchange period. How a QI structures its custody arrangements is the primary mechanism that keeps those proceeds outside the exchanger's control—and outside the reach of a disqualifying receipt event. Getting the details wrong can unwind an otherwise clean exchange.

Segregated Accounts vs. Commingled Accounts: Why the Distinction Matters

Not every QI holds exchange funds the same way. Some use a single omnibus account into which multiple exchangers' proceeds are commingled; others open a dedicated segregated account for each transaction. Both approaches can be compliant, but they carry very different risk profiles.

With a commingled account, the QI holds all exchange funds in one pooled vehicle. This is operationally simpler and is common among high-volume intermediaries. The compliance burden, however, shifts almost entirely to the QI's internal accounting: the firm must maintain meticulous sub-ledger records that trace each exchanger's specific balance, accrued interest, and disbursements in real time. A failure in that recordkeeping—or worse, a QI insolvency—can leave exchangers with limited recourse to identify and recover their specific funds.

With a segregated account, exchange proceeds for a single transaction are held in a separately titled bank or brokerage account. This structure provides cleaner audit trails, stronger protection against commingling risk, and easier identification of funds in any bankruptcy or fraud scenario. The trade-off is operational overhead: more accounts to open, manage, and close. For wealth advisors and family offices overseeing large or complex exchanges, segregated accounts are almost always the prudent choice, and a QI's willingness to offer them signals operational maturity.

Escrow Mechanics and the Constructive Receipt Trap

Whether funds flow through escrow or are wired directly to the QI after closing depends on the transaction structure, but certain principles apply universally under Section 1031 and Treasury Regulation §1.1031(k)-1.

• The exchange agreement must be in place before closing. The QI must be appointed, and the assignment of the relinquished property contract to the QI must be executed, prior to the transfer of the relinquished property. A QI that steps in after the fact cannot cure constructive receipt.
• Proceeds must flow directly to the QI. Funds that touch the exchanger's hands—even momentarily, even through an attorney trust account that the exchanger controls—can constitute actual receipt, disqualifying the exchange.
• Restrictions on access must be documented. The exchange agreement must include provisions limiting the exchanger's ability to receive, pledge, borrow against, or otherwise obtain the benefits of the exchange funds before the 45-day identification period ends and, critically, before the 180-day exchange period closes or a replacement property is acquired.

Treasury Regulation §1.1031(k)-1(g) outlines the safe harbor conditions under which a QI can hold exchange funds without triggering constructive receipt. Meeting these safe harbors isn't optional—they are the architecture of a legally defensible exchange.

The Interest Question: Who Owns It and What Must Be Disclosed

Exchange funds held for up to 180 days generate interest. On a $5 million transaction in a rate environment above 5%, that's a material sum. Yet the treatment of accrued interest is one of the least-discussed—and most frequently mishandled—elements of QI fund custody.

The IRS position is straightforward: interest earned on exchange funds is taxable income to the exchanger in the year received, regardless of whether the exchange itself is tax-deferred. It does not become boot, and it does not reduce or increase the exchange amount. It is simply ordinary income, reportable on a 1099-INT.

Where the practical problems arise:

1. Disclosure of the interest retention policy. Some QIs retain all interest earned on exchange funds as part of their fee structure. Others credit the full amount to the exchanger at closing. Many sit somewhere in between. Whatever the policy, it must be clearly disclosed in the exchange agreement—before the exchanger signs. A QI that buries interest retention language in fine print faces both regulatory exposure and client relationship risk.
2. Rate competitiveness and fiduciary optics. Wealth advisors and family offices are increasingly scrutinizing where QIs park exchange funds and at what yield. A QI holding $10 million in a demand deposit account earning near-zero while money market rates are significantly higher creates a legitimacy question, even if it's technically permissible. QIs that offer transparent, competitive interest crediting—and document it—differentiate themselves meaningfully.
3. 1099 issuance timing and accuracy. The QI is generally responsible for issuing accurate 1099-INT documentation. Errors here create downstream tax filing headaches for exchangers and their advisors, and they invite IRS scrutiny of the broader exchange record.

What Advisors Should Ask Their QI

For wealth advisors and family office principals selecting or evaluating a QI, fund custody terms deserve the same diligence as the QI's exchange agreement language. Specifically:

• Are client funds held in segregated, individually titled accounts or commingled?
• What financial institution holds the funds, and what is the credit quality of that institution?
• Is the full interest crediting policy disclosed in the exchange agreement, and what rate is being credited?
• How are 1099s issued, and by what deadline?
• What happens to exchange funds if the QI becomes insolvent—is there a fidelity bond or errors-and-omissions coverage in place?

These aren't aggressive questions. They are the minimum due diligence a professional intermediary relationship warrants, particularly when exchange proceeds represent years of a client's accumulated wealth.

Fund custody is where the abstract rules of Section 1031 become concrete. The difference between a QI that manages it carefully and one that doesn't can be the difference between a clean deferral and a fully taxable event.

This article is for informational purposes only and does not constitute legal, tax, or financial advice. Please consult a qualified tax attorney or CPA regarding your specific exchange circumstances.