The Role of Qualified Intermediaries in a 1031 Exchange

A 1031 exchange allows real estate investors to defer capital gains taxes by reinvesting proceeds from a sold property into a new, like-kind property. This strategy, under Section 1031 of the Internal Revenue Code, requires strict adherence to specific rules. A Qualified Intermediary (QI), an independent party that facilitates the transaction, is a required component for most exchanges to ensure compliance with federal tax law.

The Role and Requirements of a Qualified Intermediary

A Qualified Intermediary is necessary to prevent the investor from having “constructive receipt” of sales proceeds. Constructive receipt occurs if the taxpayer has direct control over the funds from their property’s sale, which disqualifies the tax-deferred treatment and makes the gains immediately taxable. The QI acts as a neutral third-party stakeholder, holding the funds in a secure account from the moment the initial property is sold until the new property is purchased.

The Internal Revenue Service has strict rules defining who can act as a QI, centered on the principle of independence. A QI cannot be a “disqualified person,” which is defined as someone who has acted as the taxpayer’s agent within the two-year period before the exchange. This disqualification applies to the taxpayer’s employee, attorney, accountant, investment banker, or real estate agent, as these individuals are presumed to be under the taxpayer’s control.

Vetting and Selecting a Qualified Intermediary

Investors must understand that Qualified Intermediaries are not regulated or licensed at the federal level. This lack of federal oversight means the responsibility falls on the investor to conduct thorough due diligence on a QI’s financial stability and security procedures.

Since the QI will be holding significant funds, the vetting process should focus on their security measures. An investor should inquire about the QI’s use of fidelity bonds for employee theft and errors and omissions (E&O) insurance for professional negligence. It is important to confirm that the QI holds client funds in segregated, dual-signature qualified escrow accounts at FDIC-insured banks, and not commingled with company operating funds.

QIs charge a flat fee for a standard exchange, with costs starting at a few hundred dollars and increasing with complexity. Get a clear understanding of what services are included in the base fee and what actions, such as handling multiple properties or a reverse exchange, might incur additional charges. A transparent fee schedule without hidden costs is a sign of a reputable provider.

Before making a final decision, ask potential QIs about their experience and the number of exchanges they facilitate annually. Inquire about their procedures for securing funds and their internal controls to prevent fraud. It is also wise to understand their policies in the event an exchange fails, including how and when funds would be returned.

Information and Documentation for the Exchange Agreement

Before the exchange, the investor must provide the QI with specific information. This includes the taxpayer’s full legal name, contact information, and how the property title is held. Details about the relinquished property, such as its address, the sales contract, and the preliminary title report, are also necessary, along with contact information for the closing agent.

This information is used for the Qualified Exchange Agreement, which must be signed by the taxpayer and the QI at or before the closing of the relinquished property. The agreement outlines the duties and responsibilities of both parties, establishes the QI’s role, and includes language that expressly limits the taxpayer’s rights to access the exchange funds.

The investor will also sign an Assignment of the purchase and sale agreement, which transfers their rights as the seller to the QI. A Notice of Assignment must be provided to the buyer of the relinquished property to inform them of the QI’s involvement. Preparing this paperwork accurately and having it ready before closing helps ensure the exchange complies with IRS guidelines.

The Exchange Process with a Qualified Intermediary

The exchange process begins at the closing of the relinquished property sale. The closing agent wires the net proceeds directly to the segregated escrow account held by the QI, not to the investor. This step avoids constructive receipt of the funds.

Following the closing, the 45-day identification period begins. Within this timeframe, the investor must deliver a written, signed identification of potential replacement properties to the QI. This notice must be unambiguous, include the property address or legal description, and is a strict IRS deadline.

Once a replacement property is under contract, the QI facilitates its acquisition. The investor assigns their rights as the buyer to the QI, who directs the exchange funds from the escrow account to the closing agent to complete the purchase. The deed is transferred directly to the investor, finalizing the exchange within the 180-day period allowed by the IRS. After the transaction is complete, the QI provides a final accounting statement and documentation for tax records, including information for IRS Form 8824.