Qualified Intermediary

How to Select a Qualified Intermediary for a 1031 Exchange or Like-Kind Exchange

A 1031 exchange can be an important investment tool for preserving and building wealth. Many real estate investors use 1031 exchanges to defer capital gains and depreciation recapture taxes on the sale of investment properties, as well as trade up or add additional properties to their real property portfolios.

A Qualified Intermediary -- also called a 1031 Exchange Accommodator -- plays a pivotal role in the 1031 exchange process. From completing all the paperwork to ensure a compliant exchange to holding funds in escrow from the sale of relinquished assets, QIs are deeply involved in every step of the exchange process. Selecting the right Qualified Intermediary is essential to a smooth exchange, since any error or misstep could potentially disqualify the exchange and leave you facing a substantial tax liability.

We created this in-depth guide to help investors gain a better understanding of the role QIs play in the exchange process, as well as how to select a QI. We've included a wealth of information, including who can and can't act as your QI, ways to ensure your funds are safely held in escrow, and much more. Keep reading to learn about Qualified Intermediaries and how to select one for your 1031 exchange.

What is a Qualified Intermediary and When Do You Need to Use One?

A Qualified Intermediary plays a key role in the 1031 exchange process. Foremost among them is ensuring the exchanger remains in compliance with stringent IRS 1031 exchange guidelines to help ensure the exchange is not disqualified.

During the exchange process, the QI fulfills three primary responsibilities:

1. Hold proceeds from the sale of the relinquished property in escrow since the exchanger cannot take possession of these funds throughout the exchange process.
2. Complete all documentation relating to the exchanger's identification of replacement property or properties within the mandatory 45-day identification period.
3. Facilitate purchase of the replacement property by transferring the exchanger's funds to the title company/seller.

Investors usually engage a Qualified Intermediary when they are executing a 1031 exchange. The only time it's not necessary to use a QI in a 1031 exchange is if funds are processed on the same day, which is rare. Even then, though, it can be beneficial to use a QI since they can offer important guidance and insight to help exchangers navigate the complicated exchange process. They also can help reduce the risk of making a critical error that could disqualify the 1031 exchange.

In instances where funds from a relinquished property are processed on the same day, there's a risk that the wire transfer won't be initiated on time, and a delay could disqualify the exchange. The IRS may view the exchanger as taking receipt of the 1031 fund, which would likely void the exchange and leave you with a significant tax liability on the capital gains from proceeds of your relinquished asset.

When doing a 1031 exchange, two important deadlines must be met. First, exchangers have 45 calendar days to identify up to three replacement properties from the date of closing on their relinquished asset. Second, exchangers must close upon one or more of those assets within 180 calendar days from the date of closing on the relinquished property. A Qualified Intermediary is working during this time to hold your funds in escrow and assist you by filling out all the paperwork required by the IRS to properly process the exchange.

Forms your QI prepares to ensure your exchange remains within IRS rules and regulations include:

• Formal identification of replacement properties within the 45-day window after closing on a relinquished
• A full accounting of how 1031 exchange funds are to be reinvested
• 1099 forms that are sent to the exchanger and the Internal Revenue Service

Although the QI prepares these documents, it's up to the exchanger to submit the paperwork to the IRS. In the next section, we'll cover some methods investors can use to help them select a good QI.

How to Choose a Qualified Intermediary

Selecting the right Qualified Intermediary is as important as selecting suitable replacement properties to complete your 1031 exchange. Your Qualified Intermediary should hold the funds from the sale of your relinquished asset in a FDIC-insured bank account. He or she also should be well-versed in the many nuances involved with preparing and submitting exchange documentation required by the IRS. A knowledgeable QI also understands how to facilitate the purchase of a replacement property and initiate a wire transfer to the title company.

Here are some things to consider before selecting a QI to help facilitate an exchange:

• Business history

  Typically, QIs that have demonstrated staying power in the industry can offer their clients a broader depth of experience and knowledge of IRS 1031 rules and regulations.

• Number of exchanges completed

  Volume over the last year or five years typically translates to increased knowledge of the exchange process.

• Number of non-traditional exchanges completed

  A QI with a deep history of the more complex 1031 exchange processes may have more to offer.

• How your funds are held

  Insist the proceeds from your relinquished property are held in a Segregated Qualified Trust Account or a Segregated Qualified Escrow Account.

• Where your proceeds are held

  A sk if your escrow account will be at a financial institution backed by the FDIC.

• Insurance

  Qualified Intermediaries are not regulated like stockbrokers and other financial professionals. If a QI has insurance coverage, it could protect your money from fiduciary malfeasance. Your QI should offer fidelity bond coverage and Errors & Omissions (E&O) insurance.

When you have completed this due diligence, you are ready to select a QI. Read on to learn more about how QIs work throughout the 1031 exchange process.

How does a Qualified Intermediary Work?

The first step after selecting a Qualified Intermediary is to execute an Exchange Agreement, which is a legally binding contract that defines the relationship between the two parties. Before signing it, have your attorney read it to ensure the language is consistent with any insight gained through your due diligence.

With a signed Exchange Agreement in place, the 1031 exchange process can begin. These documents must be signed prior to the close of sale on the relinquished asset to ensure the exchange adheres to IRS guidelines -- failure to do so may result in a straight sale instead of a 1031 exchange and leave you liable for significant capital gains taxes.

Your Qualified Intermediary plays an integral role throughout the exchange process. QIs perform a variety of duties, such as handling your sale proceeds to preparing all the documentation needed to satisfy exchange requirements.

Here's a closer look at how QIs advise exchangers during the exchange process:

• Adherence to deadlines

  There are strict deadlines that have to be met, most notably the 45-day identification period and 180-day closing period. A good QI helps ensure your exchange remains on track so you can meet these crucial deadlines.

• 45-day identification period

  Your QI helps prepare all documentation about replacement potential properties. This paperwork has to be signed and delivered on or by the 45th day after closing on your relinquished asset, regardless of weekends or holidays.

• 180-day closing

  During this period, which also starts from the day you close on your relinquished property, your QI verifies you have met all replacement property requirements. Once you settle on a replacement asset, your Qualified Intermediary facilitates the purchase of the property.

• Holding exchange proceeds

  1031 exchange investors cannot take receipt of any funds from the sale of their relinquished assets -- your QI must hold those proceeds. When the sale closes, exchangers assign the bill of sale to the QI, who transfers the funds into an escrow account until they are needed for closing on a replacement property.

• Preparing exchange documentation

  As you move through the exchange, your QI prepares all exchange documents and confirms their validity. Paperwork includes Assignments of Purchase, Sale Agreements, and all documentation related to the exchange.

Lastly, your Qualified Intermediary must be an independent party to the exchange. He or she should only provide advice related to the exchange and not investment advice since that's not their area of expertise.

Qualified Intermediary Fees

Qualified Intermediaries are either institutional -- subsidiaries of banks or title insurance companies -- or non-institutional independents. The fee structure for Qualified Intermediaries varies between both types:

Institutional Qualified Intermediaries

Institutional QIs usually charge for setup and administrative fees to cover the sale of relinquished assets and purchase of replacement properties. These fees can range from $800 to $1,200. They also may charge between $200 and $400 for any additional replacement properties that are part of the exchange.

Non-Institutional Qualified Intermediaries

Non-institutional QIs typically charge between $600 and $800 for setup and administrative fees.

Both types of Qualified Intermediaries earn income from the interest generated on your sale proceeds. Institutional QIs typically offset their higher setup and administrative fees through a lower portion of interest income. Non-institutional QIs, however, offer lower initial fees and take a bigger piece of the interest income -- and the difference can be substantial if they are holding several million dollars in escrow for up to 180 days.

Additional fees may include miscellaneous items such as transaction fees for wire transfers, courier charges, or overnight document deliveries. Generally, complex 1031 exchanges mean more miscellaneous charges incurred by the exchanger.

Is my money safe at a Qualified Intermediary?

Unfortunately, the QI industry is not subject to federal regulation or oversight, and just a handful of states require Qualified Intermediaries to be licensed or insured.

However, there are ways to ensure your money stays safe and protected while under the custody of your QI. This question checklist can help ensure your proceeds are safeguarded until they are needed to purchase a replacement property:

1. Inquire if your Qualified Intermediary has internal processes and audit controls to ensure the safety of your funds.
2. Ask if your funds are held in segregated, FDIC-insured Qualified Trust Accounts or Qualified Escrow Accounts.
3. Ask if exchangers have online viewing access to these accounts.
4. Inquire if funds remain liquid throughout the holding period.
5. Inquire if exchangers receive daily or monthly statements for their escrow accounts.

It's crucial exchangers perform due diligence on Qualified Intermediaries to help ensure they select an ethical and responsible QI. Many Qualified Intermediaries are members of the Federation of Exchange Accommodators, a national industry trade organization for QIs. FEA members adhere to a stringent code of ethics and may help allay some of these concerns during the exchange process.

Who can be your QI?

Exchangers are required to have a Qualified Intermediary to complete their 1031 exchange. However, there are strict rules about who can and can't act as your QI. Let's review the latter first.

The Internal Revenue Service stipulates that your QI cannot be an employee or family member. You also cannot engage anyone that's had a direct financial connection to the taxpayer completing the 1031 exchange. So regardless of a family member's financial acumen or credentials, they can't act as your QI. It's the same if you have employees -- your CFO can't be your Qualified Intermediary.

Your QI also can't have any direct financial relationship with you during the past two years. Likewise, if you have a trust with beneficiaries, they cannot act as your QI either.

Lastly, any agent you've directly engaged can't be your QI. Unfortunately, this excludes many of the professionals upon whose expertise you likely routinely rely, such as your real estate agent, investment banker, financial adviser, accountant, and attorney. Individuals affiliated with those agents also are excluded.

There are a few exceptions. Agents who form trusts, create escrow accounts, or secure title insurance can be Qualified Intermediaries since their duties are considered routine financial services. This exception allows agents to act as QIs if their work is for a 1031 exchange that results in no gain or loss during the transaction, and it only applies if those agents haven't performed any work for the taxpayer during the past two years.

Now that you know who can't be your Qualified Intermediary, let's look at who can perform this duty.

Individuals who are outside the parameters listed above can act as your Qualified Intermediary. However, they must have a QI-Employer Identification Number -- a unique number assigned by the IRS to the Qualified Intermediary. They'll need this number to release payments to the withholding agent, or the agent who distributes payments upon close of the exchange. The QI provides the withholding agent with a Form W-8IMY and has to have a QI-EIN for this document.

Your QI also will have to fill out several other IRS forms, including:

• 1042
• 1042-S
• 1042-T
• 1099
• 945
• 1096

Each form requires the use of a QI-EIN. Qualified Intermediaries receive their QI-EIN by submitting a Form SS-4 to the IRS.

How do I get my money back from my QI?

Lots of things can change during a 1031 exchange. Deals sometimes fall through, and exchangers sometimes decide to go in a different direction. If a QI is already holding your proceeds from a relinquished asset, it's important to know the steps involved in returning your funds.

There are stiff penalties in place to restrict when Qualified Intermediaries can release funds held in exchange accounts. U.S. Treasury Regulations Section 1.1031(k)-1(g)(6) (also called g(6)) – stipulates the taxpayer can't "receive, pledge, borrow or otherwise obtain the benefits of money or other property before the end of the exchange period."

Exchangers must abide by 1031 exchange regulations requirements when working with a QI. These regulations have a number of safe harbors. Foremost among them is a written agreement drawn up between the QI and exchanger stating the exchanger won't take receipt of funds until the exchange period ends, regardless of circumstances. This written exchange is binding -- if it doesn't include the g(6) limitations, then Safe Harbor isn't satisfied and your intermediary is not considered a Qualified Intermediary by the IRS.

Here are some other restrictions about releasing funds:

• Funds can't be released during the 45-day identification period, regardless of whether the exchanger decides to go in a different direction. In that case, funds can be returned after the 45-day identification window.

• If the exchanger has formally identified a replacement property, then funds can't be returned during the 180 days-to-close period. Proceeds can be returned to the exchanger on the next day after that period expires.

• Funds can be released in the event outside the exchanger's control, such as change of regulatory approval, zoning change, or natural disaster that impacts the property.

• Exchangers can designate that certain funds aren't to be reinvested and are to be taken as cash when the exchange is complete. This amount, however, has to be specified in the Exchange Agreement prior to closing on the relinquished property.

If you do want your funds back from your QI, you'll likely have to pay capital gains and depreciation recapture taxes on the full amount.

What if my QI goes bankrupt?

It doesn't happen often, but there have been documented cases of QI firms filing for bankruptcy protection.

In 2008, the year Bear Stearns collapsed and Lehman Brothers filed for bankruptcy, one of the nation's largest title companies filed for bankruptcy protection along with a subsidiary that held more than $450 million in 1031 proceeds. More than 450 investors were impacted -- yet 50 investors were fortunate enough to make an important request when executing their Exchange Agreements.

These savvy investors stipulated that their funds were to be held in segregated accounts. The others, unfortunately, had their funds held in commingled or pooled accounts that were used for investments. The lesson here: Always request that your 1031 exchange funds be held in a separate account with your QI.

Putting it All Together

Choosing the right Qualified Intermediary is imperative to a successful 1031 exchange. Your QI should have a lengthy history in the industry and demonstrate experience and a thorough understanding of the different tax codes involved in the exchange process. Your Qualified Intermediary should have no financial connection to you within the last two years, and he or she can't be a relative, employee, or agent.

Research prospective QIs thoroughly, and come armed with the questions provided here to ensure proper due diligence. A little legwork upfront could save untold grief down the road.