What Do Investors Need to Know About Qualified Intermediaries?

What is the role of a qualified intermediary in a 1031 exchange?

Real estate owners can legally defer capital gains taxes with a 1031 exchange. In delayed exchanges, which are the most common, Qualified Intermediaries receive the funds from the sale of the relinquished property and forward them for the acquisition of the replacement property. (Reverse 1031 exchanges also require Qualifies Intermediaries.)

This article answers the following questions:

• Why are qualified intermediaries necessary for 1031 Exchanges?
• Who can and cannot serve as a qualified intermediary?
• What should an investor look for in a qualified intermediary?

Why are qualified intermediaries necessary for 1031 Exchanges?

If an exchange does not comply with certain tenants of the U.S. tax code or IRS regulations, the IRS will treat it as a taxable sale and an investor may lose 20–35% of their capital gain as a result. One of these rules specifies that if an investor receives any of the funds from the sale directly (actual receipt) or even receives control of those funds (constructive receipt), the money becomes taxable. The regulations are pretty strict about what counts as “constructive receipt” of funds—for example, even the delivery of a physical check that never gets cashed may count as “constructive receipt”, which would render that money taxable.

While this rule may be simple enough to comply with in the case of a simultaneous exchange, which only requires one escrow, such cases are rare and difficult to coordinate. Most 1031 exchanges are delayed, or “Starker”, exchanges, which allow for two closings: one for the disposition of the original property and a subsequent closing for the acquisition of the replacement property.

In order for an investor to avoid receiving funds from the sale of their original property, federal regulations allow the proceeds to be held by a third party—the “Qualified Intermediary” or “QI”. This way the investor defers the receipt of any capital gain, and therefore defers the recognition of any gain on their taxes.

Qualified Intermediaries can sometimes be referred to as a “Facilitators” or “Accommodators”, and they typically support investors throughout the entire 1031 exchange process, helping them with all the necessary tax and legal paperwork required for a successful exchange.

It’s important for investors to be aware of the federal requirements that relate to Qualified Intermediaries so they can know what to expect during the exchange. Investors are ultimately the ones who will be held responsible for their property and any tax obligations that result from its disposition. Not only that, but the federal government does not require Qualified Intermediaries to obtain any special license in order to do business, and they do not actively supervise them to make sure they are complying with federal regulations and treating investors fairly. It is up to investors to make sure they understand the law and select a reputable QI in order to avoid unnecessarily high tax bills (or fraud). In reality, most QIs are reliable, and with a just little bit of education an investor can successfully carry out a 1031 exchange without any worry. Keep reading to learn about these federal requirements.

Who can and cannot serve as a qualified intermediary?

Given the principles explained above, it may already be obvious that an investor cannot serve as their own Qualified Intermediary. What might not be as obvious is that nobody who is acting as an investor’s “agent”, or who has acted as their agent within the two years prior to the exchange, may serve as the investor’s Qualified Intermediary. An agent is someone who acts on behalf of someone else. Someone acting as an investor’s agent is therefore in an important sense under the investor’s control, or representative of them, so that if an investor’s agent receives any funds from the sale of the original property, the IRS treats it as though the investor received them. The term ‘agent’ is intended to be broad, encompassing family members, employers, accountants, investment brokers, real estate agents, and attorneys.

However, IRS regulations do specify that providing certain services to an investor does not automatically disqualify someone from being their QI. These include routine financial, insurance, escrow, and trust services. And of course, just serving as an investor’s QI doesn’t count as being someone’s agent in the sense that would be disqualifying, or else these transactions couldn’t ever happen.

The good news for investors is that a number of professional Qualified Intermediaries have established reputations for being fair and trustworthy over the course hundreds or thousands of 1031 exchange transactions. 

What should an investor look for in a qualified intermediary?

1. Early Involvement
   
   1. While it may technically be possible to successfully pull off a 1031 exchange despite contacting a Qualified Intermediary the day before the close of escrow on the property to be relinquished, waiting until the last minute needlessly increases the risk of mistakes. For example, the escrow company might accidentally transfer funds to the investor, causing them to become irreversibly taxable.
      
      
2. Expertise
   
   1. An experienced QI will be able to clearly articulate the 1031 exchange property identification rules, walk an investor through closing statements, explain how property titles ought to be handled, and provide a rundown of closing requirements.
      
      
3. Insurance & Bonding
   
   1. Errors and Omissions Insurance (E&O). Qualified Intermediaries are subject to human error just like the rest of us. Even honest mistakes made by honest companies can result in costly legal fees or a QI having to come out of pocket to make up for a mistake, which only increases their risk of bankruptcy. It is therefore important for QIs to insure against the risk of errors and omissions with a policy carried by a reputable insurer. There shouldn’t be any gaps in its coverage, and it should cover settlements, judgements, and legal fees.
      
      
   2. Fidelity Bonding. In addition to insuring against honest mistakes, Qualified Intermediaries should insure against fraud, forgery, and theft. This policy should also be carried by a reputable insurer so that the investor can be reimbursed if their capital is lost as a result of this kind of infidelity.
      
      
4. Thorough Exchange Agreement
   
   1. Specify Treatment of Funds. The agreement between the QI and the investor should clearly and thoroughly specify how the QI will handle the investor’s funds at each stage of the process.
      
      
   2. Provide a Fair & Transparent Fee Structure. The exact nature of the QI’s fees should be disclosed, including any interest that might be earned during the exchange period (which should only be at issue if deposits do not exceed the FDIC insurance limit). Typical fees can range from $500–$2,500 for delayed exchanges and $2,500–$7,500 for reverse exchanges, due to the increased complexity and risk of such transactions.
      
      
   3. Specify the Property Identification Rule in Play. The exchange agreement should specify which of the three property identifications rules the investor will be complying with, including details about the timeframe.
      
      
5. Conservative Account Structures
   
   1. Segregation of Accounts. A QI should not hold investor funds in their own company accounts or comingle funds from separate investors in common accounts so that even if a QI were to declare bankruptcy an investor’s funds will be protected from delay or seizure and the investor may still be able to complete their exchange.
      
      
   2. Trust or Escrow Accounts. Recent court rulings have treated funds held in accounts under a QI’s name as corporate funds and therefore part of their bankruptcy estate. However federal regulations allow Qualified Intermediaries to hold investor funds in qualified trust or escrow accounts with trustees, so that they are treated as fiduciary funds rather than corporate funds, protecting them from bankruptcy on the part of the QI.
      
      
   3. Dual Signoff on Accounts. Since an investor cannot take actual or constructive receipt of their funds, the money must be held in an account that requires the QI’s approval on transfers. However, there is no need for the QI to be the sole signer on the account. Dual signoff complies with federal regulations while protecting investors.
      
      
   4. Non-Interest Bearing Accounts if Deposits Exceed FDIC Limits. Although federal regulations allow an investor to benefit from an interest-bearing account, their Qualified Intermediary may take all or part of that interest as a fee. This can make interest-bearing accounts attractive to investors and QIs, however if deposits exceed the FDIC insurance limit and something happens to the funds, the investor may lose all of their funds. Putting all of an investor’s capital at risk is not worth it.