By Steve Haskell, Senior Vice President at Kay Properties and Investments
When checking off the boxes for your 1031 exchange “to do” checklist, choosing a qualified intermediary should be on top of that list. The IRS requires exchangers to employ a qualified intermediary (aka “QI, “accommodator,” or “facilitator”) to receive the funds upon sale of the exchanger’s property. Section 1031 of the Department of the Treasury Regulations authorizes the QI to receive and hold the funds, advise on compliance matters, and prepare all agreements and documentation pertaining to the 1031 exchange transaction to ensure the exchange is executed properly under the Internal Revenue Code and Treasury regulations.
Exchangers are putting a tremendous amount of their wealth and trust in the hands of these qualified intermediary entities. Therefore, it is important to make an educated decision when selecting a qualified intermediary. Here are a few questions to ask QI candidates prior to selecting one for your exchange.
How experienced are you?
Find out how many exchanges they have done, how long they have been in service, and how much in exchange funds they are currently holding. You should collect this information for both the company as well as the officer that has been assigned to your account. The 1031 Exchange is a nuanced process and attention to detail is extremely important. It is critical that you are equipped with sound guidance and the administration of your exchange is properly managed. Otherwise, it could result in a painful tax consequence and/or a failed exchange.
What type of internal control processes are in place to protect my exchange funds?
The QI should be able to provide you with a written copy of their internal policy that outlines the safety measures in place to potentially protect your funds. One of the most important being that the QI CALLS YOU AND CALLS THE CLOSING AGENT PRIOR TO WIRING THE FUNDS. They should not simply disperse the information when contacted by the seller’s escrow/closing agent.
Is your firm licensed?
The IRS does not require QIs to be regulated. QIs can choose to obtain a license and fall under the regulation of various agencies in order to increase their credibility and ensure they are maintaining certain standards when handling client funds. Therefore, you should always find out if your QI is licensed and by whom they are regulated and audited.
Do you hold clients’ 1031 Exchange funds in either a separate Qualified Trust Account or a Qualified Escrow Account?
It is important that the QI holds the funds in a Qualified Trust Account or a Qualified Escrow Account. Some firms will offer accounts that are “comingled” with other exchanger’s money. You should be able to receive a statement of your account at any time that shows how much and where your money is being held.
Do you carry errors and omissions (E&O) insurance?
Some QI’s have a fidelity bond that only covers themselves. Others offer coverage to other parties in the exchange. The more coverage they have, the more your funds are potentially protected.
How do you ensure against embezzlement and employee theft?
Though it is rare, it is important that your funds are insured from nefarious activity. You should find out if your QI’s fidelity bond coverage is “per occurrence” or merely “in aggregate”. Ask the QI for proof that their coverage is still active and in full effect.
What are the QIs hours?
It is important to know if/how you can contact the QI after business hours, especially as you near the end of your 45 day window. You should also know the absolute last minute QI will receive your identification for the replacement property. Do they accept ID’s over the weekend? At night? What if your 45th day falls on a Sunday?
How are my funds managed/invested while with the QI?
Find out if your funds are held in a bank account or placed in various investment vehicles. If your funds are invested, make sure you understand the policy that guides how and where your funds are invested.
Mismanagement of funds, fraud, and bankruptcy is rare in the QI industry however it has happened before. Most companies do a satisfactory job. However, one mistake could lead to costly consequences. Therefore, it is critical that you take the time to do your due diligence when selecting the right QI for your exchange.
Why You Need a 1031 Exchange Qualified Intermediary
If you’re considering a 1031 exchange, you can’t exactly do it alone. Not only do you need to follow IRS rules to a T to get the tax benefits, but you’ll also need qualified intermediary for a 1031 exchange, also known as a QI. But what’s important to look for, and how should you make the decision? Let’s review the basics.
What Is a 1031 Exchange?
Whenever you’ve held property for a period of time and then sell it, you typically have to pay capital gains tax on the profit. For example, if you sold a property for $100,000 that you bought for $50,000, you’d have to pay taxes on the $50,000 in profit. But a 1031 exchange allows you to defer the taxes via buying another “like-kind” asset and saving the taxes for when you sell that property — though you could always do another 1031!
It’s called a 1031 because the rule is governed by Internal Revenue Code Section 1031(a)(1), which is the section of tax law that outlines the practice. It’s not quite as clear-cut as we’ve illustrated here — there are also time restrictions and your next property must be equal or greater in value than the property you just sold — and you’ll also need a 1031 exchange intermediary to help facilitate the transfer.
Previously, 1031 exchanges were possible with artwork, vehicles and other personal property, but the Tax Cut and Jobs Act discontinued the practice as of January 1, 2018.
Who Can Be a Qualified Intermediary?
Unfortunately, you can’t use just anyone as your 1031 exchange intermediary because IRS Section 1031 specifically states that an intermediary can’t be a parent or child, nor a sibling. The law also stipulates that your 1031 exchange intermediary can’t be an agent of yours, such as an attorney, CPA, real estate agent or broker.
But beyond that, a 1031 exchange agent can be anyone. However, 1031 exchanges are complicated, and if anything goes wrong you could be on the hook for thousands in extra taxes. That’s why it’s important to hire only those with experience in managing 1031 exchanges, lest something goes wrong with your filing.
The Responsibilities of a Qualified Intermediary
In a nutshell, a 1031 exchange qualified intermediary will sell a property for you, then buy the replacement property and transfer the ownership to you. It sounds simple, but there are a lot of places where it can all go wrong. Your 1031 exchange intermediary is responsible for collecting the funds, preparing documentation and contracts, and ensuring that it all goes off without a hitch and in accordance with IRS guidelines.
But before you even sell your property, you’ll have to sync up with your qualified intermediary for the proper paperwork that outlines their role in the process, as well as the properties that you’re buying and selling. That will help preserve the tax deferral benefit, which is ultimately the whole point of a 1031 exchange.
Additionally, a 1031 exchange intermediary is responsible for coordinating and drafting all the paperwork, as well as organizing documentation for the sale and purchase of both properties. During escrow, they’ll also work with the title company and receive the funds after the sale of the first property. Those funds will be deposited into a separate account, where they will be held for 45 days.
Your 1031 exchange intermediary will also be tasked with organizing the process to purchase your next property, and signing over the deed to you. After that, they’ll have to establish a complete accounting of it all, including filling out tax forms.
After all that, your 1031 exchange would be completed and you’ll only be on the hook for those taxes when you sell your new property — as long as you don’t do another 1031 exchange.
Requirements of a 1031 Exchange
Because a 1031 is a complicated tax maneuver, there are several requirements that the IRS will check on to determine if you’ve engaged in a proper 1031 exchange. One of those requirements has to do with the exchange documents that are prepared by the 1031 intermediary. In fact, these have to be drafted and signed before the first property is sold, otherwise it’ll be treated as a taxable sale and a separate, unrelated purchase.
Another requirement of a 1031 exchange is the same taxpayer requirement, which means that both the sold property and the replacement property must be held by the same taxpayer. Under a 1031 exchange, that’s the qualified intermediary, though it is possible to leverage a single-member LLC since those are disregarded under the tax law. That means your exchange intermediary can sell one property and buy the other with a single-member LLC or a grantor trust, which is also disregarded for tax purposes.
A 1031 exchange stipulates that only investment or business properties qualify, meaning that personal properties are not eligible under the 1031 exchange rule. Furthermore, the two properties must be like-kind properties, though, to be fair, all real property is considered like-kind, so any two pieces of real estate can qualify.
To receive the full tax benefit of a 1031 exchange, there are also time constraints, such as a 45 day window from the transfer of the first property to identify a replacement property. With no exceptions, including weekends or holidays, this so-called identification must be made in writing and signed by the taxpayer.
Following the identification window, there is also something called an exchange deadline, which stipulates that the replacement property must be acquired within 180 days of the transfer of the relinquished property or whenever the taxpayer’s tax return for the sale is due, whichever is first. Like other deadlines, there are no exceptions and no extensions, even for holidays or weekends.
However, there are some instances where a replacement property may be acquired prior to the transfer of the relinquished property, which is known as a reverse exchange. It’s a little more complicated than a traditional 1031 exchange, but it can enable title holding or parking so that a proper 1031 can be enacted.
That said, if at any point you include a disqualified person in your 1031 exchange, such as a relative, employee, attorney, accountant, agent or broker, your 1031 will be invalid and you’ll owe the associated taxes from your sale when next year’s tax return comes around. That’s why it’s best to always use a 1031 exchange qualified intermediary that knows what they’re doing. You’ll avoid any hiccups or snags in the 1031 exchange process, and that means no additional taxes come tax time.