A 1031 exchange refers to Section 1031 of the Internal Revenue Code, which allows taxpayers to defer the recognition of capital gains taxes which would otherwise be due from selling investment property if the investor replaces the sold property with a “like-kind” asset of the same or higher value. At the outset, this exchange was a real-time event (and it was possible to transact using other assets in addition to real estate), but over time it has developed such that most exchanges transpire on a delayed basis. As a result, protocols need to be in place to ensure that the taxpayer doesn't control the proceeds from the sale of the property they are relinquishing during the time before the purchase of the replacement.
Maintaining the separation of those funds is one of the vital responsibilities of the Qualified Intermediary (also sometimes referred to as a 1031 exchange accommodator). The QI can be a person or a company, but they must be a neutral third party. The QI may not be related to (or married to) the taxpayer and can’t be employed by that individual or be their agent (including their attorney, accountant, broker, or anyone else in a close advisory role). In addition to controlling the funds disbursed from the initial property sale, the QI will be responsible for the following functions:
- Safeguard critical documents.
- Oversee escrow for related transactions.
- Supervise maintenance of arms-length relationships between taxpayer and buyers and taxpayer and sellers.
- Receive and hold identification of potential replacement properties.
- Acquire selected property or properties and transfer title.
- Create detailed accounting of all transactions.
Individual or Institutional
While there are no legal eligibility requirements for Qualified Intermediaries, a trade association called the Federation of Exchange Accommodators acts as an advocate and provides educational opportunities for professionals. The FEA also has referrals for consumers who want to know more about QI qualifications and practices.
Some QIs work as standalone professionals, while others are subsidiaries of financial institutions providing the service to multiple clients. In either case, they will often charge an administrative fee for the service and sometimes retain some of the interest that the funds earn while in escrow. If the QI charges a smaller set-up fee, they may keep a more significant portion of the earned interest. The investor needs to review the terms to understand the fee structure.
In addition to the administrative fee (with a wide range of amounts from as low as $300 to as high as $1,200) and a percentage of the earned interest, the qualified intermediary may charge additional fees for specific items in more complex exchanges. For example, if the transaction includes seller financing, that may result in an additional cost. Another example is a transaction in which one party is deceased or in the midst of marital dissolution. One helpful note to keep in mind is that, in general, if the exchange accommodator charges a higher administrative (set-up) fee, they may require a lower portion of the earned interest and vice versa.