A Qualified Intermediary plays an essential role in successfully executing any 1031 exchange. This professional has several critical responsibilities to ensure that the exchange complies with IRS regulations. Perhaps most importantly, the QI takes possession of the proceeds from the sale of the identified property when it is sold and maintains those funds separately from the investor until they are used to complete the exchange into replacement property (or properties).
What Is a 1031 Exchange?
The term 1031 exchange or "like-kind exchange" refers to Section 1031 of the Internal Revenue Code, relating to the deferral of capital gains taxes. If an investor sells an investment property, they may defer the payment of capital gains taxes by reinvesting the proceeds into a like-kind replacement property of equal or greater value. The IRS has been generous with the interpretation of "like-kind," and almost any investment real estate is qualified. But the process must be followed stringently for the exchange to be eligible, and that is where the use of the Qualified Intermediary becomes crucial. The QI must coordinate these vital tasks:
- Establishing and maintaining a separate account to hold the funds from the relinquished property sale (to which the investor may not have access).
- Receiving and documenting the identified replacement properties and preparing the appropriate legal instructions.
- Completing the purchase transaction for the replacement assets.
Is a Qualified Intermediary the Same as an Exchange Accommodator?
The IRS refers to Qualified Intermediaries, but other sources often use Exchange Accommodators or Facilitators. Even the industry association, the Federation of Exchange Accommodators, uses the terms interchangeably. The FEA offers a certificate program for exchange specialists, but there are no legal qualifications. However, the IRS has listed who a QI may not be:
- Family members. The QI cannot be related to the taxpayer (parent, child, sibling, or spouse), but someone related by marriage is allowed.
- Any agent of the taxpayer may not fulfill the QI function. This prohibition includes the person’s attorney, real estate broker or agent, accountant, financial advisor, and employees.
While the investor's accountant or real estate broker may not serve as their QI for handling the 1031 exchange, these experts may be excellent referral sources. In addition, there are QIs affiliated with banks and other financial institutions and others who work independently. The investor should thoroughly investigate the qualifications of the person or firm they choose and consider these questions:
- Ask about internal controls to safeguard your funds during the process. For example, it's advisable to request that your account be segregated from others' money.
- Ask if you can view the funds online during the process.
- Ask if the funds will remain liquid.
- Ask for regularly scheduled statements of the account balance.
Choosing a well-qualified and experienced intermediary is crucial to the exchange's success. The IRS is strict about the timelines for identifying replacement properties and the execution of the transactions involved in the exchange. Failure by the QI can result in disqualification of the 1031, resulting in an unwanted tax bill.