Because you are absolutely not allowed to receive (or directly control) any of the proceeds from the transfer of your relinquished property in a 1031 exchange — if you do, you will instantly turn your tax-free Section 1031 exchange into a taxable sale — it is necessary to employ the services of a Qualified Intermediary (also sometimes called a QI or an exchange accomodator) in the 1031 exchange process.
A Qualified Intermediary is the person or business entity that holds the exchange proceeds and acts as a “safe harbor” or barrier between the taxpayer and the proceeds from the transfer of the exchange property, so that these proceeds never come into your actual or constructive possession, but at the same time can be used to obtain new property for you.
The sale proceeds go directly to the Qualified Intermediary, who holds them until they are needed to acquire the replacement property. The Qualified Intermediary then delivers the funds directly to the closing agent.
If the taxpayer meets the requirements of this safe harbor, the IRS will not consider the taxpayer to be in receipt of the funds.
The IRS originally refused to allow deferred exchanges under Section 1031 because the taxpayer received the proceeds from the transfer of the relinquished property before using these proceeds to obtain replacement property. To the IRS, this receipt of funds in the period between the completion of the exchange made the transactions into a series of sales and purchases rather than a true exchange.
The current law allows the taxpayer a limited period of time after the transfer of relinquished property to identify and obtain title on replacement property, but also reflects the IRS’s concern over the taxpayer’s receipt of the proceeds in the interim by requiring that there be no receipt of cash or other non-qualified property by the taxpayer before both ends of the exchange have been completed.
As a result of this rule, a new professional came into being: the Qualified Intermediary.
Since the taxpayer can not receive the proceeds from the relinquished property until title to the replacement property is obtained, and these same proceeds are used to acquire that replacement property, someone needs to hold on to the funds, acquire the relinquished property from the taxpayer; transfer the relinquished property to another party, acquire the replacement property from another party, and then finally transfer the replacement property to the taxpayer. This is the job of the Qualified Intermediary.
Specifically, the Qualified Intermediary:
- Enters into a written agreement (called an exchange agreement) that documents all important aspects of the exchange.
- Acquires the relinquished property from the taxpayer.
- Transfers the relinquished property to another party.
- Acquires the replacement property from another party.
- Transfers the replacement property to the taxpayer.
The properties are usually deeded directly between the parties, just as in a normal sale transaction. However, in a Section 1031 exchange, unlike an ordinary sale, the taxpayer’s interests in the property purchase and sale contracts are first assigned to the Qualified Intermediary. The Qualified Intermediary then instructs the property owner to deed the property directly to the appropriate party (for the relinquished property, its buyer; for the replacement property, the taxpayer).
Because the proceeds can never come into your actual or constructive possession before the completion of the exchange, there are limitations on who can serve as a Qualified Intermediary in a Section 1031 exchange.
Anyone who is an agent of the taxpayer at the time of the transaction, or has been an agent of the taxpayer within the past two years, is disqualified from being a Qualified Intermediary of the taxpayer.
This prohibition includes anyone who has been the taxpayer’s employee, attorney, accountant, investment banker or broker, real estate broker or agent within the past two years from the date of the transfer of the first of the relinquished properties.
In practical terms, this prohibition eliminates your present lawyer or accountant from serving as your Qualified Intermediary.
However, assuming there are no other disqualifying activities or relationships, you may use a real estate agent who has previously helped to put together a Section 1031 exchange for you, as well as a business entity or person who has performed routine financial, title insurance, escrow, or trust services for you.
Despite the importance of using a Qualified Intermediary in the Section 1031 exchange process, qualified intermediaries are generally not regulated (the single exception is in Nevada).
Remember that the Qualified Intermediary is an actual principal in the exchange transaction. You must assign to the Qualified Intermediary your interest as seller of the relinquished property and your interest as buyer of the replacement property. The Qualified Intermediary will be responsible for holding the proceeds of the transaction in a separate exchange account until the funds are used to obtain the replacement property.
For these reasons, your Qualified Intermediary must be someone you trust to hold your money or land and who has plenty of fidelity bond insurance in place.
You should also take special note of the Qualified Intermediary’s fund management program, asking in whose name the funds are held and where, and what the requirements are for deposits and withdrawals.
In addition, you should also make sure that your Qualified Intermediary is experienced in the Section 1031 exchange process.
Remember that the rules governing the use of the proceeds of the various transactions in Section 1031 exchanges can be complicated, and that a mistake by your Qualified Intermediary can result in you paying thousands of dollars in taxes that could, and should, be avoided.
Remember, too, that it is not the job of the Qualified Intermediary to provide legal or specific tax advice to the exchanger. On these critical matters, you must have expert and trustworthy advice from other professionals.
To contact Melissa J. Fox about serving as a qualified intermediary or for other 1031 exchange services, send an email to firstname.lastname@example.org