The successful execution of a 1031 exchange can allow an investor to defer payment of capital gains taxes. This tactic can help you leverage your investment capital, but to obtain approval from the IRS, you must carefully follow the rules governing the 1031 exchange transaction. If you make a mistake, the IRS may disqualify the exchange, resulting in you having to pay the capital gains taxes immediately.
The investor must employ the services of a Qualified Intermediary to oversee the exchange in almost every case. The QI, sometimes referred to as an Exchange Accommodator, has several critical responsibilities in the process:
1. The QI creates a separate account to maintain the sale proceeds, using the funds to complete the replacement property purchases. Since the investor is precluded from having access to the funds during the exchange period, this provision is vital.
2. The QI formally receives the identification of potential replacement properties, as selected by the investor, within 45 days of the original asset sale. The successful completion of an exchange depends on the timely identification of potential asset acquisitions.
3. The QI oversees the collection of all applicable documents the investor needs for adequately reporting the exchange to the IRS.
There is no legal certification for a Qualified Intermediary, although there are credentials to look for. The IRS doesn’t specify what person or entity may serve as a Qualified Intermediary, but they do offer a list of who cannot fill the role. Some of the prohibited parties are:
Family members. While the rules disqualify blood relatives and spouses, in-laws are acceptable.
Employees and agents. Anyone who works for the investor or has acted professionally on their behalf is excluded. This category of disqualified individuals includes your attorney, broker, financial adviser, and CPA. However, it's a good idea to seek referrals from those trusted associates for intermediaries to consider.
Financial connections. Anyone with financial involvement with the taxpayer may not act as their QI. This category includes someone with whom you own a business, someone who works for the same company you work for, and anyone who is either a beneficiary or trustee of a trust that you established or may benefit from.
Since you can’t employ as QI someone with whom you conduct business, or a trusted associate or family member, it’s essential that you focus on the qualifications and experience of the person or company you select. Consider the individual's tenure in the financial business and how many exchanges they have completed. Many QIs are members of a national trade association—The Federation of Exchange Accommodators. The association conducts background checks and requires members to follow their ethics policy. In addition, it provides continuing education and other resources to its members.
Investors may also want to ask the QI professional or service provider about the methodology for holding funds. For example, choosing a provider that agrees to segregate your escrow funds from those of other clients is a good idea. While you may be able to save money by allowing your funds to be mingled with other clients’ money, the practice increases the risk of loss. Also, ensure that the company maintains sturdy control policies to protect you from loss.