Get complete, easy-to-understand explanations of 1031 exchange rules and guidelines.
In order to complete a successful 1031 exchange, an investor must not take constructive receipt of the proceeds from the sale of the relinquished property. If an investor were to receive any money such as a wire from escrow to their bank account or even an uncashed check with the closing proceeds, this capital would become irreversibly taxable. To avoiding taking constructive receipt of the proceeds during a 1031 exchange, it is imperative that an investor have a Qualified Intermediary (“QI”) hold the capital during the period between the sale of the relinquished property and the acquisition of the replacement property.
The Role of a Qualified Intermediary in a 1031 Exchange
A QI receives the proceeds from the sale of a 1031 investor’s relinquished property from the buyer and then, when it is time to close on the replacement property, forwards the funds for the purchase of the replacement property to the seller. The QI also helps the 1031 investor with the appropriate tax and legal paperwork throughout the transaction to show that an investor complied with the 1031 guidelines laid out by the IRS. For this reason, QIs are often called “Facilitators” or “Accommodators.”
While it is clear that QIs are essential to the 1031 exchange process (with the extremely rare exception of a simultaneous closing on both the relinquished and the replacement properties), there are several considerations an investor must be aware of when selecting a QI for their exchange. It is especially important that investors are careful in selecting the right QI since this particular industry is unregulated and has a number of pitfalls that could put the investor at risk of a failed exchange—or worse: the loss of some or all of their principal!
IRS Guidelines for the Use of Qualified Intermediaries Under IRC §1031
There are three general guidelines an investor should follow while working with a QI in order to comply with the IRS requirements forbidding constructive receipt for a tax-deferred exchange.
- The Qualified Intermediary Cannot Be Under the Control of the Investor
- Since the investor cannot receive the proceeds from the sale of the relinquished property, no one under the control of the investor can receive the proceeds either. QIs must be unbiased third parties. The QI cannot presently be—or have been within the two prior years—the 1031 investor’s family member, employee, attorney, accountant, investment banker or broker, or real estate agent or broker.
- That said, companies offering routine financial, title insurance, escrow, or trust services for the 1031 investor are not disqualified from serving as the QI in a 1031 exchange. Also, a company that has served as a QI for the investor in the past is allowed to do so again.
- A Qualified Intermediary Needs to Be Involved in the 1031 Exchange Process Prior to the Sale of the Relinquished Property
- It is important to engage the QI early in the process, prior to closing, to ensure that the seller and escrow company are aware of the intent and procedure to complete a 1031 exchange and that the net proceeds of the sale will be sent to the proper QI account.
- While it is possible to set up a QI account the day before (or even the same day of) a closing, this increases the risk that the close of escrow may be delayed or that the escrow company may revert to sending the proceeds to the investor instead of to the QI. Therefore, it is important to have set up the QI contract and account ahead of time to reduce risk to the closing and to help ensure a smooth 1031 exchange.
- The Trust or Escrow Accounts Must Require the Qualified Intermediary’s Approval as an Authorized Signer Prior to Transferring Funds
- As the investor cannot ever take constructive receipt of the proceeds, it is important that the signature of the QI be required to transfer funds.
- However, it is permissible for an Exchange Agreement to require a “dual signoff,” which can provide the highest level of protection for an investor. The “dual signoff” requires both the 1031 investor and the QI to sign off on any transfer of funds. Since the investor cannot move the funds without the QI’s signature, this avoids constructive receipt. Since the QI cannot move the funds without the investor, this provides an additional layer of protection for the investor’s capital.
- Bottom line: EITHER the sole signature of the QI OR both the signature of the QI and the signature of the 1031 investor must be required to ensure that an investor is not taking constructive receipt.
Finding the Right Qualified Intermediary to Protect Your Money
In addition to complying with the IRS guidelines to complete a successful 1031 exchange, an investor must know what to look for in a good QI to protect their capital and their tax-deferred status during the exchange process. One of the biggest risks an investor can take is picking an Accommodator that puts investors’ money at undue risk during the exchange process. Additionally, not all QIs are created equal, and many are very relaxed about properly applying the 1031 exchange requirements. This puts investors at risk of invalidating their exchanges and opens up the QI’s clientele to additional scrutiny by the IRS. There are seven essential requirements that investors should look for in a QI to ensure that their capital is protected, the tax-deferred status of their capital is preserved, and they are being reasonably charged for the services provided.
- The Trust or Escrow Accounts Used by a Qualified Intermediary for Exchanges Must Be Segregated
- It is typical for an active QI to facilitate multiple 1031 exchanges simultaneously. It is critical that the QI segregates the funds for each exchange into separate accounts that are held distinctly for the benefit of each individual exchanger. A segregated account protects an investor in the event that a QI runs into financial difficulty or declares bankruptcy.
- Since the account is separate and designated for the benefit of the investor, it is likely that the funds would be returned to the exchanger or used to facilitate the exchanger’s 1031 rather than be tied up in bankruptcy proceedings. However, if a QI were to comingle exchangers’ funds (which some QIs do as a regular course of business), the situation would take much longer to unwind in a bankruptcy. In extreme cases, some or all of the capital could go to other lienholders in the bankruptcy rather than to the original exchangers.
- Bottom line: Ensure that your Accommodator uses segregated accounts.
- The Qualified Intermediary Must Use Non-Interest-Bearing Accounts if the Deposit Amounts in an Exchanger’s Account Exceed FDIC Insurance Limits
- Investors should make sure that their QI is using a non-interest-bearing account to hold their proceeds if they exceed FDIC insurance limits. Since many QIs make some of their profits from the interest that they earn off the exchange proceeds between transactions, they will typically default to using interest-bearing accounts. However, if anything were to happen to a QI that held exchange proceeds in excess of FDIC limits in interest-bearing accounts, it would be possible for the exchanger to lose the money that exceeds the insurable amount.
- If your proceeds exceed FDIC limits, the risk of losing your principal greatly exceeds the interest you could earn during the exchange period. Ensure that you are covered by the FDIC limits or that your capital is in a non-interest-bearing account so that you do not put it at risk during a potential bank failure.
- The Qualified Intermediary Ought to Maintain E&O Insurance
- Qualified Intermediaries ought to maintain an errors and omissions (E&O) insurance policy, without gaps in coverage, from a reputable insurance provider. Errors and omissions insurance protects the 1031 investor and the QI from the risks associated with actual or perceived errors and omissions performed by the QI during the exchange period. This is similar to malpractice insurance in the medical field. Depending on the details of the policy, E&O insurance may cover judgments, settlements, and legal costs.
- While a 1031 investor ought to work with a competent QI, mistakes are always possible. Even when the QI is not in error, there may be significant legal costs involved in defending against a suit. E&O insurance reduces the risk that the QI will be in a position to file bankruptcy during a 1031 investor’s exchange period.
- Use Only Qualified Intermediaries that Carry Fidelity Bonding
- While E&O insurance protects against unintentional mistakes such as errors and omissions, fidelity bonding protects against intentional wrongful acts such as fraud, theft, and forgery. QIs ought to maintain fidelity bonding from a reputable provider to transfer the risks associated with deliberate wrongful acts to another party and thereby decrease the risk of bankruptcy. Fidelity bonding may also reimburse your proceeds in case of a triggering event that negatively impacts your exchange capital.
- The Qualified Intermediary Should Be Well Established and Experienced
- The 1031 exchange process can be quite complicated at various stages, and it takes a competent, well-established QI to provide services for an investor that properly comply with 1031 exchange requirements. Mistakes on the part of the QI could negatively affect the 1031 timeline or transaction and trigger a taxable event.
- Ensure that your QI is experienced and understands the following:
- 1031 exchange requirements so that they can properly advise and guide clients through a successful transaction (not understanding the process accurately can cause a client to end up blowing part or all of their exchange)
- proper use of the three replacement property identification rules and the deadlines provided by the IRS (the QI ought to know how to use the 200% and the 95% rules in addition to the three-property rule to accommodate more-complex exchanges)
- paperwork required to show a clear paper trail for a completed 1031, including the closing statement, exchange titling, closing requirements, etc.
- In some cases, QIs are affiliated with, or owned by, major title or trust companies, which may provide a degree of protection for investors insofar as this potentially indicates strength and/or potentially implies backing for the QI by the affiliate or parent company. On a separate note, this would, at the very least, suggest that this is not a fly-by-night organization.
- The Exchange Agreement Ought to Be Clear and Thorough
- The relationship between a 1031 investor and a QI is governed by a contract called the “Exchange Agreement.” It is important that this contract spell out exactly how funds are to be transferred and held. It ought to require the QI to place the funds where and how the 1031 investor directs. It should detail any and all fees and provide the exchanger with accurate confirmation of the anticipated identification and closing deadlines by which the QI and the exchanger will be bound in order to comply with 1031 exchange requirements.
- The Qualified Intermediary Ought to Offer Equitable Pricing
- Typical QI fees range from $250 to $2,500 to facilitate a delayed (Starker) 1031 exchange (the most common type of exchange, which uses the 45-day identification and 180-day closing periods). For reverse exchanges, fees tend to range from $3,000 to $7,500 since QIs take on more risk and have to facilitate a much-more-complicated transaction. Fees can also vary based on the complexity of the transaction, how many properties are involved, the amount of capital involved, the amount of risk perceived, and any special requirements of the exchange.
- For most delayed (Starker) 1031 exchanges that involve the sale of one property and the acquisition of one to three or four different properties/investment offerings, fees should generally be in the flat $500-to-$800 range among QIs that provide all of the characteristics recommended above. There is no reason to pay more for a typical 1031 exchange.
- For reverse exchanges, pricing depends on the circumstances, and it is more difficult to lay out a range of equitable pricing without knowing the particulars of the exchange.
Do You Need a Qualified Intermediary?
1031Gateway maintains relationships with a select number of industry-leading QIs that meet the criteria above and whose prices are on the lower ends of the ranges specified. If you are considering a sale of investment or business property and want to defer your capital gains taxes utilizing a 1031 exchange, we can connect you with a QI that meets the criteria laid out in this article and will provide you with discounts when you are referred by one of our representatives. Fill out the form at the top of this page, email email@example.com, or call (800) 818-1031 today to learn more.