A Qualified Intermediary is an entity that creates documentation supporting a taxpayer’s intent to initiate an Internal Revenue Code Section 1031 tax deferred exchange and holds the exchange proceeds in a manner that preserves principle and liquidity. The Qualified Intermediary’s role is to provide input, helping the taxpayer understand how a 1031 exchange works and interfaces with the title company or closing attorney, so the closing statements reflect a 1031 exchange.
What is a 1031 Exchange?
When real property and improvements are held as an investment or held in the productive use of a business and then sold, federal and state capital gain and depreciation recapture taxes are triggered. In some states, like California, the aggregate tax can be as much as 40 percent of the sales price. If the taxpayer engages a Qualified Intermediary, follows the 1031 exchange rules and replaces with real property held in the productive use of a business or for investment of equal or greater value than the net sales price, the tax is deferred until the replacement property is sold. On a $400,000 sale of a condominium, potential taxes of $160,000 can be deferred indefinitely, representing an interest free loan.
The 2018 tax law went into effect January 1, 2018, changing the 1031 tax code from including tangible and intangible personal property to only real property. No longer are business aircraft, equipment, collectibles, rental cars and franchise rights eligible for 1031 treatment. Capital gain tax rates were not changed.
Is a Qualified Intermediary Required in a 1031 Exchange?
In a “pure” exchange where there are only two parties to the exchange, the Taxpayer and the Buyer, then no, a Qualified Intermediary is not required. In a three or four party exchange, including the Taxpayer, Buyer of the old property and Seller of the replacement property, then yes, a Qualified Intermediary is required. The g(6) constructive receipt limitations of the 1031 code prohibit the taxpayer from touching the exchange funds or the net equity from the sale. The Qualified Intermediary creates an escrow account with a bank or financial institution to hold the funds until one of the following conditions has been met:
- The acquisition of replacement property
- The 46th calendar day post-relinquished property closing and replacement property candidates have not been formally identified
- The 180th calendar day should replacement property candidates be identified to the Qualified Intermediary and none of the candidates were acquired
Who is Disqualified from acting as a Qualified Intermediary?
The Qualified Intermediary must be a third party, independent of the taxpayer. A disqualified person cannot act as the Qualified Intermediary if considered the agent of the taxpayer at the time of the exchange. A person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date of the transaction is treated as an agent. There are exceptions to the rule, such as if the person has provided routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution or title/escrow company.
An attorney or CPA cannot act as the taxpayer’s qualified intermediary if the attorney or CPA has performed legal or financial services, respectively, for the taxpayer within the two-year period of the transaction unless such services were with respect to exchanges of property intended to qualify for a 1031 tax deferral. Granted there are attorneys and CPAs who have accommodated exchanges despite having provided non-exchange related services to the taxpayer within the two-year period. Doing so deprives their clients of the safe harbor provisions of the exchange regulations and could be considered an ethical violation or malpractice if challenged on that basis.
Questions to ask a Qualified Intermediary?
When considering engaging a Qualified Intermediary, ask the following questions:
- What is the QI’s expertise? Does the QI specialize or have adequate experience with the exchange? Is a Certified Exchange Specialist® on staff? Is this their full-time occupation or part time? Know who you are trusting with your funds and with the 1031 exchange documents.
- How are the exchange proceeds protected? There are a variety of types of security offered to protect the funds. FDIC insurance is available up to $250,000 per account. Is a Qualified Escrow Agreement utilized requiring dual signatures, one from the taxpayer and one from the Qualified Intermediary to authorize escrow account disbursements?
- How accessible is the Qualified Intermediary? What are the office hours and is the QI available after hours and weekends?
- What is the Qualified Intermediary fee? Most qualified intermediaries price their services either on a flat fee or percentage of the selling price. Interest earned on the exchange proceeds can be either be split with the Exchangor or all to the Exchangor or all to the Qualified Intermediary. If the exchange proceeds are over $2,000,000 then the Exchangor receives a minimum interest rate equivalent to the 13-week US Treasury rate.
How to Find a Qualified Intermediary
The Federation of Exchange Accommodators (FEA) is an association representing hundreds of Qualified Intermediaries. Each year members are subjected to a criminal background check and adherence to an Ethics Policy. The following link provides the contact information by state for the membership. Given the 1031 tax deferral is a federal statute, the location of the Qualified Intermediary does not restrict them from accommodating the exchange. The Qualified Intermediary can accommodate exchanges around the world and throughout the United States given they adhere to state regulations.