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A 1031 exchange serves as a great strategy to defer taxes for investors considering a real estate sale. The “like-kind” swap is not a taxable event, so there’s no liability for any capital gains you make after the transaction. However, the IRS has set strict rules to ensure that such exchanges aren’t abused and are conducted according to existing guidelines.
One critical element of a 1031 exchange is the qualified intermediary (otherwise known as the 1031 exchange accommodator). These entities serve as the main facilitators of the exchange, and working with the right qualified intermediary brings you closer to a successful asset swap.
What are the specific tasks of a qualified intermediary? How do you choose one that can address your needs? Below, Realized 1031 has shared an article detailing the role of the 1031 accommodator to answer these questions, giving you more confidence when vetting and working with one. Keep reading to learn more!
The Complexity of a 1013 Exchange
Taxes from capital gains can soar to thousands of dollars for investors. As such, tax deferral strategies like 1031 exchanges have become an opportunity to preserve capital and avoid major tax liabilities. This like-kind exchange, named after Section 1031 of the revenue code, allows investors to swap assets like real estate property for another that’s similar. Since no sale occurred, the investors don’t have to pay any taxes — only when they finally sell the property do they have to report their gains.
The IRS has set specific rules to ensure that investors follow the processes outlined by the agency for a 1031 exchange. Apart from the like-kind requirement, there’s the 180-day deadline, identification of property, and equal or greater value requirement. If you fail to adhere to these timeframes and stipulations, the IRS may disqualify you from the tax benefits, leaving you paying hefty capital gains taxes.
1031 exchanges are complex, so there’s a chance for investors to make mistakes. As such, the IRS has made it mandatory for most 1031 exchange investors to work with qualified intermediaries. These entities serve as a neutral third party that facilitates the entirety of the exchange.
What Is a Qualified Intermediary?
A qualified intermediary is an entity that oversees a 1031 exchange, serving as a party separate from the property seller. The IRS requires the property owner to have no direct control of the sales proceeds to qualify for the tax deferral. An accommodator creates this separation, allowing the exchange to remain compliant with the requirements of Section 1031.
While there are no specific certifications set by the IRS for qualified intermediaries, there are rules on who cannot serve as a qualified intermediary for an investor. To preserve the neutrality requirement, you cannot hire an accommodator with whom you have professional or personal relationships. These include the following.
- Family Members: All blood relatives are automatically not allowed to become your qualified intermediaries.
- Employees and Agents: Any type of professional who has worked on your behalf is disqualified. These include your attorneys, accountants, and brokers.
- Financial Connections: Any entity with whom you have financial involvement cannot serve as a qualified intermediary. Some examples are business partners and beneficiaries of a trust that you established.
The primary function of a qualified intermediary is to facilitate the legal transfer of the property by selling the relinquished property (the property being sold) and purchasing the acquired property (the new investment) on behalf of the exchanger. This setup prevents what’s known as “constructive receipt” of the sales proceeds. In this scenario, the money from the sale would be under full control of the investor — income, in short. Holding income would trigger a taxable event for the investor and make them disqualified from receiving a tax-deferred status.
To prevent constructive receipt, the qualified intermediary takes the proceeds and holds them in escrow. The cash stays in this separate account until the investors acquire the new property.
Another important role of the accommodator is preparing the documents for the exchange. As such, a qualified intermediary must have knowledge about the rules of the IRS and ensure that the investor remains compliant with the requirements. You’ll typically find qualified intermediary services from many financial institutions, title companies, and law firms. These entities are already familiar with IRS regulations and have the resources to ensure accuracy and convenience.
There are companies dedicated solely to providing qualified intermediary services. Often, they can provide tailored solutions that fit your specific situation or the asset to be exchanged. However, not all intermediaries are created equal. Understanding the qualifications and responsibilities of an accommodator is critical to choosing one who can address your needs.
Examining the Role of a Qualified Intermediary in the 1031 Exchange Process
As the overall facilitator of the 1031 exchange, a qualified intermediary has the following specific roles in each step of the transaction.
1. Exchange Setup
The first stage of the 1031 exchange happens before you relinquish your current property. The IRS doesn’t allow you to start after, so you must begin working with a qualified intermediary after deciding to do a 1031 exchange. Otherwise, the IRS will disqualify you from the tax deferral benefits.
Engaging with a qualified intermediary is more than just a means to stay compliant. This entity will be the one typically drafting the major documentation required to set up the process, including the exchange agreement. This document specifies that the accommodator will hold the sales proceeds and oversee the purchase of the replacement property on your behalf.
2. Sale of the Relinquished Property
After the initial setup, the investor can proceed to sell their current property. The main professional that you need to work with is a real estate broker or agent, but your qualified intermediary will still play a part during closing. To avoid constructive receipt of the money, your accommodator will receive the funds from the buyer. That way, you remain compliant with the IRS and avoid making an official sale.
3. Identification Period
Within the 180-day timeframe, 45 days are allotted to identifying the like-kind property. This step is not as simple as it may seem, with the IRS requiring proper documentation to ensure that the options follow the agency’s guidelines. Your qualified intermediary ensures that you follow the identification process and remain compliant.
You can identify up to three properties as potential swaps. The more you add to your options, the more documentation you’ll need to accomplish. Having a qualified intermediary overseeing this process may make you less prone to errors and ensure that you submit everything within the 45-day deadline.
4. Holding the Exchange Funds in Escrow
As you identify properties for acquisition, the proceeds from the sale of your relinquished will remain in the possession of the qualified intermediary. The money will be in escrow or a segregated account, with the accommodator releasing it only when you find a suitable like-kind property.
This holding period is critical because the exchanger cannot have access to these funds to avoid constructive receipt. Thankfully, your money will be under robust legal protection while it’s held by your qualified intermediary. Most of the companies offering this service offer additional services like regular updates on the status of the funds. Some may even offer segregated funds as another level of protection for your capital.
5. Acquisition of the Replacement Property
Upon identification of the replacement property, the next step is its acquisition. The qualified intermediary has another critical role to play: coordinating the transfer of funds from the escrow to the account of the replacement property’s seller. Since you won’t be handling the money on your own, it will be the accommodator who makes the payments on your behalf. The qualified intermediary will also ensure that the transfer happens within the 180-day timeframe set by the IRS.
6. Final Steps
After transferring the escrow funds, the qualified intermediary will also handle the transfer of the title from the seller to you. This is the final step of the 1031 exchange process. After this last responsibility, your accommodator can step down and let you take full ownership of the property. Since you didn’t directly handle the proceeds of the sale, you can now enjoy the tax-deferred status and use your capital for other ventures.
Responsibilities and Obligations of a Qualified Intermediary
A qualified intermediary is more than just an entity that facilitates the sale and purchase process during a 1031 exchange. This individual must navigate complex tax regulations, meet strict deadlines, and act as a neutral third party throughout the transaction. Here are some of the key responsibilities of a 1031-qualified intermediary.
Maintaining Full Control of the Proceeds
Selling or exchanging a real estate asset requires the movement of a large amount of cash. Letting go of this huge amount, even temporarily, will make anyone uneasy, not just investors. Qualified intermediaries provide a level of assurance for investors so they can be more confident about where their capital is going as they try to avoid constructive receipt.
While the intermediary holds the funds, they may also create another account for it. The separation from the accommodator’s main account adds another level of protection. You can trust that your capital is being maintained responsibly.
Drafting the Documentation
One of the most critical documents during the entire transaction is the exchange agreement. This one outlines the terms and conditions of the transaction. Plus, the exchange agreement states that the qualified intermediary is responsible for handling the sales process and purchasing the property on behalf of the investor. As such, it’s important for the accommodator to know how to draft an exchange agreement that follows IRS guidelines. Working with one who knows the ins and outs of exchange agreements can help ensure that the transaction remains compliant.
Some essential contents of the exchange agreement are the following:
- The parties involved in the transaction, which may include the investor, the owner of the relinquished property, and the qualified intermediary.
- The terms of the exchange, including the exchange ratio, deadlines, and the responsibilities of each named party.
- A provision stating that the investor or property owner is not considered to have realized gains or losses after the exchange.
Adherence to IRS Deadlines
One core obligation of a qualified intermediary is ensuring the timeliness of the exchange. The IRS sets strict deadlines for a variety of reasons. For one, this timeframe prevents investors from delaying the recognition of their gains or losses just so they can file it the following year. Another rationale is to ensure that the entire transaction is done in a timely manner.
45-Day Rule
The IRS gives about six weeks for investors to identify the like-kind properties. These are calendar days, so even weekends are counted within the timeframe. Your qualified intermediary won’t help with the search — that is your task. However, the accommodator will take over the documentation and submission to the IRS before the deadline.
180-Day Rule
The other deadline the accommodator monitors is the 180-day timeframe, which covers the entirety of the transaction. This begins right after the sale of the relinquished property and ends after closing.
Safeguarding the Exchange Funds
The intermediary must act as a trustworthy steward, ensuring that the funds in escrow are not only maintained but are also protected and accessible upon the purchase of the new property. As such, your accommodator must not use your money for other investment purposes, such as giving it out as a loan or using it to fund another real estate transaction.
It will be up to you to require a separate account for your funds. Some companies offer this benefit while others offer it as an extra security measure. Whatever the case, your chosen intermediary must remain in open communication regarding the status of your money as a reassurance that it’s in safe hands.
Facilitating the Purchase
The qualified intermediary does more than transfer the proceeds to the account of the property seller. This entity is also responsible for many other aspects of the closing process, such as the transfer of the title and recording of the deed. As we’ve mentioned, you’re not supposed to be involved heavily in the official steps of the sale, keeping yourself at arm’s length. Otherwise, you trigger a taxable event and create a situation where you’re liable to pay capital gains taxes. Letting the accommodator take care of things is how you can remain qualified for the tax-deferral benefit.
Maintaining Impartiality
An accommodator acts as an impartial party that ensures you follow IRS guidelines and is not allowed to provide investment advice, nor can they offer legal guidance. As such, it’s the qualified intermediaries responsibility to remain independent. This is why direct relationships with the exchanger are prohibited. You may only work with a qualified intermediary that remains objective and won’t cater to your personal interests.
Tips and Best Practices for Choosing a Qualified Intermediary
The accommodator you choose to work with will have a major impact on the success or failure of your 1031 exchange. Given the immense responsibility of the qualified intermediary, selecting one that isn’t up to the task won’t just be inconvenient. You could fail to follow the IRS guidelines and get disqualified from the tax deferral benefits. As such, it’s critical to find one that is trustworthy and has the right experience to ensure a smooth and compliant exchange. Here are a few strategies you can try.
1. Find an Accommodator With Proven Experience
The IRS guidelines can become complicated. An experienced QI will have a deep understanding of the IRS regulations and the intricacies of like-kind exchanges, helping you navigate the process with ease. The experienced accommodator can also help you minimize risk and reduce costly mistakes. More specifically, they can anticipate potential issues and provide guidance to help you avoid them.
Another benefit of working with an experienced qualified intermediary is that they can provide clear information about the exchange, allowing investors to gain an in-depth understanding of the process and rationale behind the strict rules. This knowledge allows you to be more confident with the transaction while also keeping you informed about the potential challenges ahead.
How do you determine if a qualified intermediary has enough relevant experience in 1031 exchanges? Here are a few things you can ask.
- The number of years providing 1031 intermediary services. Ask your selection regarding how long they’ve been providing services. While longevity doesn’t automatically mean expertise or good service, there’s a high chance that an established qualified intermediary company can provide systematic and tailored solutions.
- You can also ask about the specific types of assets they work with. In this article, we’ve been focusing on real estate assets. However, any type of capital asset can be exchanged. As long as the like-kind requirement is satisfied, you can swap business assets, stock, and interests in a partnership. However, each type of asset has specific requirements. As such, choosing an intermediary that focuses on real estate when you want to exchange stock may not be the best practice. Opt for one that specializes in the type of asset you want to exchange.
- Another important proof of an intermediary’s experience is reviews and testimonials from past clients. Make sure to ask for references from past investors to determine if the company does deliver on its promises.
2. The Qualified Intermediary Should Have Robust Security Measures for Your Funds
You wouldn’t want just any intermediary handling what could be hundreds of thousands or millions in proceeds from the sale. Hence, it’s important to choose an accommodator that has safeguards in place to protect your funds. The best ones offer segregated accounts for your money, separate from the one they use for operations. This added layer of protection ensures that your capital won’t get touched in case the intermediary faces financial difficulties during the 180-day holding period.
Here are a few things you can investigate to determine the extent of the intermediary’s security and protection for clients’ funds.
- Ask about the methods used by the company or individual to secure client funds. Escrow accounts are the standard practice, but you can also ask if a segregated account is an inclusion in their services. Another possible method is a trust account. In this case, the trustee ensures that the money is only used for the purposes of the 1031 exchange.
- You should also inquire about the types of insurance or bonding the company carries to protect your money.
- Inquire about the ways the accommodator can ensure transparency and clear communication about the status of your funds during the exchange.
- We also recommend asking about the technologies they use to secure your fund and sensitive client information. What kind of protocols do they have for the increased threat of cyber attacks on financial institutions? What protections have the company set up to protect from global outages like the recent Crowdstrike glitch? Working with a qualified intermediary that is prepared for such scenarios is one way you can ensure that your funds are protected.
3. Choose a Qualified Intermediary That Follows Legal and Ethical Standards
As we mentioned above, the IRS doesn’t require specific certifications for qualified intermediaries. Unlike professionals like attorneys or real estate agents, accommodators don’t also need a license. Instead, the QI will need to prove to the IRS that they have the ability to comply with the set regulations and standards.
The IRS will ask for periodic certification that accommodators must regularly submit. The document bears information about the company as well as confirmation of compliance with IRS regulations. If there are changes to the company’s structure or ownership, these should also be reflected on the periodic certification.
Another thing you can check is if the 1031 accommodator is a member of professional organizations such as the Federation of Exchange Accommodators (FEA). This association sets standards for ethical conduct and continuing education for 1031-qualified intermediaries. In fact, FEA is the only national trade association that represents professionals handling 1031 exchanges. Engaging with a qualified intermediary that is a member of FEA gives assurance that you’re working with a company dedicated to following the best industry practices.
One more aspect to look at is whether the intermediary has the means to ensure compliance with IRS rules regarding disqualified persons and conflict of interest. We recommend choosing ones that conduct due diligence on all parties involved to determine if there are any conflicts of interest that could result in your disqualification.
4. Qualified Intermediaries Should Be Transparent With Their Fees
It’s important to find an accommodator that has a clear fee structure. Otherwise, you might get caught off guard by hidden fees that eat away from your capital. The costs can vary, with factors like the complexity of the exchange and the extent of services provided affecting the fees. A trustworthy qualified intermediary should be transparent with their fees upfront — they won’t suddenly create surprise charges as the transaction progresses.
During the selection stage, don’t settle with the intermediary that offers the lowest fees. A low-cost company may not have the necessary experience to handle major exchanges. Others may be cutting corners or providing subpar services that put you in danger of disqualification. Instead, find the right balance of reasonable fees and a strong reputation.
Here are a few questions you can ask to gain relevant information on the company’s fee structure.
- What is the free structure and are there additional expenses during the holding period that I should know of?
- How do your fees compare to those of other qualified intermediaries? This question helps you gauge the reasoning behind the lower or higher rates. If you’re hesitant to ask this question, you can compare the fee structures of each company in your selection.
- What services are included in the fees? This question helps you determine if services like creating a segregated account cost extra.
5. Clear Communication and Reliable Availability
In a 1031 exchange, the deadlines are strict and the process can be meticulous. As such, clear communication is essential for all parties. We recommend choosing an accommodator who is reliably available for your questions and is able to provide updates regularly.
You can get a feel of the company’s communication style during the initial consultations, so pay attention as you talk to the ones in your selection. Ask about their preferred communication style (e-mail, video conferencing, in-person meetings, etc.) and if they can make small compromises to adapt to yours. Look for a qualified intermediary that is responsive and proactive, especially one that has clear protocols about client communication during the exchange.
During the initial consultations, you can ask the following questions.
- How often will you send updates throughout the 1031 exchange process?
- Do you use secure messaging platforms or are in-person meetings the ideal setup?
- How do you handle urgent or time-sensitive matters that may happen outside of regular business hours? The ideal qualified intermediary should be able to provide timely assistance for critical issues, even when they’re not in office.
Potential Risks Associated With Qualified Intermediaries
Despite the requirement of using qualified intermediaries in 1031 exchanges, there are still potential risks that investors may face. Knowing these pitfalls and challenges helps you take the right measures and minimize the chances of issues that could disqualify you from the tax benefits. Here are some of the common issues you need to be aware of.
Fraud or Mismanagement of Funds
As we’ve emphasized above, most qualified intermediaries will have robust measures to ensure proper management of the sale proceeds. However, nothing is certain in the investment world. There is still a possibility that the intermediary could misappropriate, mishandle, or even abscond with the funds. While these scenarios are rare, some intermediaries have stolen their clients’ funds and used the money to fund their lavish lifestyles.
How can you avoid fraud? While there is no sure guarantee that you’ll never encounter a fraudulent accommodator, you can minimize risk by thoroughly verifying their credentials. Find ones that have a proven track record. Members of FEA are also more likely to be trustworthy since they’re beholden to certain industry standards.
Another way to protect your money from mismanagement is insisting on segregated accounts. This practice reduces the risks of commingling. So, even if the intermediary faces financial issues, your funds remain untouched. Finally, make sure to work with a qualified intermediary that carries fidelity bonds or errors and omissions insurance. These could cover any potential losses due to fraud or negligence.
Disqualification From Tax Deferral Status
Losing the tax-deferred status of the exchange can result from a myriad of factors, and one of these is a qualified intermediary that fails to comply with IRS rules. It should be a given that an accommodator must follow regulations like the 180-day deadline, but mistakes and negligence can still occur. Failing to submit the right documentation will automatically result in recognized capital gains and significant tax liability.
It’s not just the deadlines — the documentation itself could contain errors because the accommodator is inexperienced or careless about the process. Incorrect details could also result in the loss of the tax benefits.
As such, it becomes even more essential to engage with a qualified intermediary who has a strong background in the ins and outs of 1031 exchanges. Working with such companies can lower the chances of errors and missed deadlines. On your end, it’s crucial that you remain aware of the exchange process and the deadlines. That way, you can monitor what stage of the exchange you’re in and if your accommodator has accomplished the tasks during this stage.
Lack of Oversight and Regulation
As we mentioned, there is no direct regulatory oversight over qualified intermediaries. There’s no federal licensing, either. Given the relative laxness, anyone can technically become a qualified intermediary. This issue increases the risk of investors unwittingly working with inexperienced or unqualified accommodators. Even if you’re meticulous about your vetting process, it’s still hard to gauge the competency of a qualified intermediary. Testimonials and referrals can only go so far.
To reduce the risk, always work with qualified intermediaries that have FEA membership. FEA is not a regulatory body by itself, but its members follow high ethical standards that add a level of assurance. Plus, the association offers continuing education that increases the knowledge base of its members.
Another best practice is to ask for referrals from reputable past clients. Don’t just settle with Google reviews or ones posted on the intermediary’s website. Ask for real people — especially professionals like accountants and lawyers — who have worked with the company in the past. That way, you can get more objective opinions about the accommodator.
Potential for Legal and Financial Liabilities
Mishandling the funds or failing to meet IRS regulations could lead you to financial or legal liabilities. In certain scenarios, unscrupulous accommodators may deceive you into thinking that the exchange has been successful. They’d leave before the IRS comes to scrutinize the transaction and make you pay penalties or back taxes. In some cases, the qualified intermediary may face litigation that leaves your funds at risk.
There are a few things you can do to guard against these challenges; first is choosing a stable intermediary that doesn’t have any record of financial issues. You should also select a company that has the right insurance coverage. That way, even if they are ordered to pay for a legal liability or file for bankruptcy, they can’t touch your funds.
Companies and Institutions Offering Qualified Intermediary Services
Many types of companies, usually ones in the financial sector, offer qualified intermediary services. Each one has varying levels of expertise, service, and security, so it will be up to you to choose the ones that can address your needs as an investor.
Banks and Financial Institutions
Banks and large financial institutions like credit unions are common providers of intermediary services. These ones have robust infrastructure, established protocols, and strong financial security measures that make them a reliable choice. Plus, these entities can offer additional fiduciary services that give you more confidence about the movements of your funds. They also carry fidelity bonds and errors and omissions coverage that also protect investors from financial loss.
Title and Escrow Companies
Title and escrow companies also may offer qualified intermediary services as part of their property transaction facilitation. Given how these businesses already handle processes like holding funds in escrow and transferring titles, they are likely well-equipped with the knowledge and resources to handle 1031 exchanges. Another advantage of such entities is how they can provide solutions tailored for property owners and investors. This added flexibility provides a more convenient experience for their clients.
Independent Qualified Intermediaries
The first two options above are considered institutional intermediaries because they are under a bigger company. Conversely, there are businesses that exclusively provide qualified intermediary services, which are called non-institutional.
The main benefit of independent qualified intermediaries is that they may offer more flexible and personalized solutions to each client.
For all three choices, you’re still required not to have any prior relationship with the financial entity and the professionals behind it. However, if two years have elapsed since you last worked with the person or institution, the IRS will allow them to become your qualified intermediary. Due diligence is still the best practice to determine the eligibility of potential accommodators.
Wrapping Up: Examining the Role of Qualified Intermediaries in 1031 Exchanges
Qualified intermediaries play a crucial role when it comes to like-kind exchanges. These entities help investors keep an arm’s length from the entire transaction, ensuring its tax-deferred status. As such, the accommodator handles most aspects of the process, such as crafting the exchange agreement, submitting documents to the IRS, and most importantly, holding the sale proceeds on behalf of the investor to prevent constructive receipt. By working with an experienced, trustworthy, and dedicated qualified intermediary, you’re one step closer to a successful 1031 exchange.
For more information about accommodators and 1031 exchanges, get in touch with Realized 1031 today.
The tax and estate planning information offered by the advisor is general in nature. It is provided
for informational purposes only and should not be construed as legal or tax advice. Always
consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.investopedia.com/terms/c/constructive-receipt.asp
https://cybermagazine.com/articles/the-main-cyber-threats-facing-the-financial-sector
https://www.irs.gov/businesses/corporations/qualified-intermediary-general-faqs
https://www.oakridger.com/story/news/2009/03/20/man-guilty-scamming-132-million/47178215007/
https://www.kiplinger.com/real-estate/1031-exchange-rules-you-need-to-know
