Do I earn interest on my exchange funds, and is it taxable?

The exchange agreement, not the bank statement, decides whose earnings these are

Your money will earn something; whether you ever see it is a contract term you negotiate before closing. Reg. §1.468B-6(c)(1) provides that exchange funds are treated as loaned from a taxpayer to an exchange facilitator, and in that case the facilitator must take into account all items of income attributable to the funds.

The default flips in exactly one situation. Under §1.468B-6(c)(2), where the agreement provides that all the earnings attributable to your exchange funds are paid to you, the loan treatment disappears and you must take those items of income into account instead.

So the question to put to an intermediary is not what rate it pays. It is whether the exchange agreement contains the sentence that assigns the earnings to you, and the answer belongs in writing before the relinquished property transfers.

Your name and TIN on the account, a credited sub-account, or a pro-rata slice of a pool

The regulation recognises three ways the earnings can be measured. A separately identified account is one established under your name and taxpayer identification number with a depository institution, and §1.468B-6(c)(2)(ii)(A) deems the earnings credited to it to be all the earnings attributable to your funds.

A sub-account inside the intermediary's master account qualifies too, but only where the depository institution identifies that sub-account by your name and TIN and specifically credits earnings to it. A spreadsheet entry kept by the intermediary is not the same thing.

Where funds are commingled, §1.468B-6(c)(2)(ii)(B) requires a pro-rata allocation using a reasonable method that takes into account the time your money was in the account, the actual rate or rates of return, and the respective balances. Ask which of the three describes your file.

The fee may be netted out of the earnings, but only if it was fixed before you closed

An intermediary can deduct its own fee from the earnings and still satisfy the all-earnings test, because §1.468B-6(c)(2)(ii)(C) treats any payment of a transactional expense out of your funds as first paid to you and then paid by you to the recipient.

That only works if the fee qualifies. Under §1.468B-6(b)(4)(ii) the facilitator's fee is a transactional expense only where the agreement fixes the amount on or before the date you transfer the relinquished property, and the fee is payable by you regardless of whether the earnings are sufficient to cover it.

The regulation's Example 3 shows the mechanics: a $1,200 fixed fee retained out of $21,000 of earnings, with the taxpayer still taking the full $21,000 into income. A fee quoted as 'whatever the account earns' fails both halves of the test.

Why a 'no-fee' intermediary is not free, and the arithmetic on a 150-day hold

A zero-fee quote means the firm is paid from the float rather than from an invoice. Exeter's published fee guidance states that most of a QI's income is generated from the interest income earned on the investors' exchange funds, and that intermediaries retain all or a portion of that income during the exchange period.

Run the numbers on a hypothetical $1,000,000 of net proceeds held for 150 days at a 4% annual rate: roughly $16,400 of earnings. Against that, a fixed $1,250 invoice with the earnings credited to you is the cheaper arrangement by an order of magnitude.

The spread can be invisible even when you are paid. In Examples 5, 6 and 7 of §1.468B-6 a bank credits the intermediary additional interest, or a marketing fee, calculated on the total exchange funds it holds on deposit; none of that is treated as earnings attributable to your account, so the intermediary keeps it and your agreement still passes the all-earnings test.

Smaller exchanges narrow the gap. A hypothetical $250,000 held for 40 days at the same 4% earns about $1,100, which is close to what a fixed fee would have cost.

Above $2,000,000 or past six months, you can owe tax on earnings you never received

Letting the intermediary keep the earnings means you made it an interest-free loan, and §7872 can charge you with the interest anyway. Reg. §1.7872-16(b) treats an exchange facilitator loan as a demand loan, and §1.7872-16(c) makes a below-market one a compensation-related loan.

The escape hatch is narrow. Reg. §1.7872-5(b)(16) exempts the loan only where the amount treated as loaned does not exceed $2,000,000 and the duration is six months or less; both conditions must hold, so a $2.5 million exchange fails the test on day one.

The regulation prices its own example. On $2,100,000 held three months at a 91-day rate of 4%, forgone interest is $7,000 in the first year and $14,000 in the second, deemed transferred by the taxpayer to the intermediary as compensation and retransferred by the intermediary to the taxpayer as interest.

The rate is not whatever the intermediary earned. Reg. §1.7872-16(d) uses the lower of the short-term AFR in effect on the day the loan is made, compounded semiannually, or the investment rate on the 13-week Treasury bill issued on or most closely before that day.

Whatever you are owed, it stays locked up until the exchange period ends

Earnings do not sit outside the safe harbor. Reg. §1.1031(k)-1(g)(5) preserves the safe harbor where you are or may be entitled to interest or a growth factor only if the agreement expressly limits your right to receive it in the way paragraph (g)(6) requires.

When it finally reaches you, §1.1031(k)-1(h)(2) treats an interest or growth factor as interest regardless of whether it is paid in cash or in property, including property of a like kind. Applying it to the replacement purchase price changes the cash flow, not the tax.

In practice a February closing with a July purchase produces a Form 1099 for money you could not touch until July. The same restriction on the principal is set out in Can I touch, borrow against or pledge my exchange funds?.

Six questions to settle before you sign the exchange agreement

The Federation of Exchange Accommodators puts this on its own checklist for choosing an intermediary, in the form 'Is interest earned on funds held by the QI during the exchange?' Push past the yes or no and get the mechanics.

• Does the agreement state that all earnings attributable to my exchange funds are paid to me?
• Is the account in my name and TIN, a sub-account the bank credits to my TIN, or a commingled pool allocated pro rata?
• What rate is credited, how often is it credited, and who keeps anything the bank pays you above that rate?
• Is your fee a fixed dollar amount stated before my closing and payable whether or not the earnings cover it?
• Who issues the Form 1099 for the earnings, you or the depository institution, and against which taxpayer identification number?
• What errors and omissions cover or deposit do you carry? California requires an exchange facilitator to maintain at least $250,000 of E&O insurance or an equivalent deposit under Financial Code §51007.