After you think you’ve completed a successful 1031 exchange, the last thing you want to do is receive a tax bill from the Internal Revenue Service (IRS) notifying you that the exchange was invalidated. Unfortunately, many investors find themselves in this situation because they fail to use a qualified intermediary (QI) to facilitate the process. A 1031 exchange qualified intermediary is required for this real estate transaction.
A QI ensures that investors comply with regulations and requirements for them to benefit from deferring tax on a 1031 exchange property. If you want to avoid capital gains taxes on the sale and have a smooth experience, having an experienced QI is essential. In this guide, we define a QI, discuss what they do, and show how they can help you navigate the complicated 1031 exchange process.
What Is a Qualified Intermediary?
To know what a qualified intermediary does, you first have to define “intermediary.” This term refers to a person who acts as a mediator, go-between, or link between people to bring about an agreement.
A 1031 qualified intermediary, also referred to as a 1031 exchange facilitator or 1031 exchange accommodator, is a person, entity, or company that enters into a written contract with the real estate investor to complete the exchange transactions on their behalf. This person, entity, or company oversees the entire process and the exchange of funds and ensures the process adheres to 1031 exchange requirements.
The QI will create documentation to support the investor’s intent to initiate the 1031 exchange and preserve liquidity and principle until the exchange is complete. This documentation will also include the exchanger’s identification of replacement property within the mandatory 45-day identification period. Throughout the process, the QI will offer their expertise and input and help the investor understand how the procedure works.
What Are the Primary Responsibilities of a QI?
One of the main functions of the QI is to restrict the investor’s access to the sale proceeds after the sale of the relinquished property. Taxpayers are required to pay taxes on any income received in any given year. To defer paying taxes on one’s income, the taxpayer must defer receipt of that income by avoiding both actual receipt and constructive receipt of that income.
Actual receipt of income is fairly uncomplicated, meaning that the taxpayer directly receives the actual income into their possession, placing it in their personal bank account or spending it according to their wishes. Constructive receipt, on the other hand, refers to income that is not directly paid to the taxpayer, but placed under the taxpayer’s control for them to access, administer or distribute as they determine.
Most exchanges fall under the category of a delayed 1031 exchange, in which the sale proceeds are not directly transferred to the seller of the replacement property and must be held until the closing of a replacement property. To avoid a taxable event through actual receipt or constructive receipt of these funds, the investor cannot accept or hold the sale proceeds from the sale of the relinquished property. The Safe Harbor rules, as listed in IRS Section 1.103, require the investor to use a QI to act as an escrow holder for these funds.
The ownership of the property to be sold is transferred to the QI, which then sells the property and holds the sale proceeds until a like-kind replacement property is purchased by the QI with the fund being held. At that time, the QI then transfers ownership of the replacement property to the investor, leaving the investor in possession of property rather than funds.
Delayed 1031 exchanges cannot proceed without a QI.
Who Is Disqualified From Acting as a Qualified Intermediary?
Practically anyone can become a qualified intermediary for a 1031 exchange, as there are no federal regulations governing the industry. However, some states do have certain limits and restrictions, including specific standards, licensure, financial stability, and liability insurance coverage a qualified intermediary must have. Additionally, the qualified intermediary cannot be a related party to the investor. The person or company must be completely independent, such as a third-party entity.
According to the IRS, a QI cannot fall under the category of a disqualified person, which means anyone who has acted as an agent for the investor within the last two years before the exchange took place. Here are some examples of disqualified people under these restrictions as they relate to the investor:
- An employee
- A certified public accountant (CPA)
- An investment banker
- A broker
- A real estate agent
- A relative
Any person who falls into these categories is considered an agent of the investor, and, therefore, is not qualified to become their QI. There are some exceptions to this rule, however. For example, if the person has provided routine financial services for the investor through a title or escrow company or financial institution, they can still be a QI. Otherwise, providing these services for the exchange can be seen as an ethical violation or malpractice.
What to Look for in a Qualified Intermediary
When it comes to a qualified intermediary, it’s essential to choose carefully and consider their expertise, fees, and many other factors. Due to the level of responsibility of a QI in these exchanges, it’s critical to select a reliable and trustworthy person for this role. Here’s how to choose a qualified intermediary.
Experience Level and Licensing
It is important to choose a QI carefully since there is little state or federal regulation on QIs. With no licensing requirement, any agent can become a QI as long as they do not fall into one of the few categories that are restricted from acting as a QI, such as those listed above.
Furthermore, QIs often hold large sums of money on behalf of the investors they serve and often do not have a guarantee of security on those funds if the QI were to become bankrupt. While some states do not require licensure for QIs, it’s wise to work with one who has earned their licensure or certification because it shows they have the relevant education and qualifications to oversee your exchange.
When looking for a potential QI, you’ll want to know their licensing and experience level. Choose a QI who has been in business for a long time and has plenty of background in the related field. This means they have experience in both understanding the laws and regulations and handling 1031 exchanges from start to finish.
You’ll likely want to ask them questions about their experience, such as how long they’ve worked with 1031 exchanges, what mistakes they’ve made, and why investors choose them over other QIs. You can also inquire about the dollar amount for the exchanges they’ve performed in the past. Ideally, you’ll want to choose a QI who has handled transactions of the same size as yours.
Insurance, Bonds, and Funds Management
A reliable and trustworthy QI should carry insurance and follow certain procedures to protect your finances and interest, including:
- Errors and omissions insurance: QIs are required to have errors and omissions coverage, which provides financial protection from negligence and errors if your QI makes a mistake with your paperwork. This coverage enables you to collect damages from the insurance company.
- Fidelity bonds: Your QI should hold fidelity bonds, also known as crime insurance, of at least $1 million. These bonds cover claims based on criminal, fraudulent, or dishonest activity, such as if one of the QI’s employees steals money from your account.
- Funds separation: Different QIs may make different decisions on how the funds are pooled and invested during the time in which the QI has possession. Your QI should maintain fund separation to ensure your money is not blended with funds from other clients, which can lead to having it seized if your QI declares bankruptcy during your 1031 exchange process. All QIs must hold the funds in FDIC-insured banks.
A qualified intermediary in real estate should uphold exceptional customer service. As with any person, company, or entity in the industry, customer service plays a pivotal role in choosing a QI. You’ll want to examine the quality of customer service they provide, how responsive they are to your questions, and whether they seem to be willing to help you understand more about the exchange process rather than simply overseeing it.
The first step to judging their level of customer service is by looking up their reviews and references to get an idea of their overall reputation. If they’ve been in the industry for years, they’ll likely have plenty of reviews and testimonials online from investors who have worked with them in the past.
Feel free to read through these to get an idea of how they treat their customers. You can also ask your potential QI for references from customers. If they seem hesitant or cannot provide these references, it’s probably a sign that they do not have happy customers or have not performed many 1031 transactions.
You can also gauge a potential QI’s customer service ability by contacting and interacting with them directly. Whether it’s by phone or through email, be sure to connect with them using their preferred contact method. See how fast it takes them to respond and assess their willingness to help and consult with you about your 1031 exchange. Meeting with a QI willing to educate you on the process and provide instruction will benefit your exchange.
Costs and Fees
QIs have different fee structures. Some may charge a flat rate, while others may consider the interest earned on the funds during the period the funds are held. Likewise, the interest earned on the funds may be paid in different ways by different QIs.
With that in mind, a QI with extensive experience and expertise is worth more money. While it’s important to consider pricing in your decision, if you want premium services and sufficient coverage, you’ll have to pay more. Generally, most QIs charge around $700 to $1,100 for delayed exchanges, but these numbers can change depending on the complexity of your exchange.
Luckily, you can request a quote from potential QIs to help guide your decision. In addition to the base prices, be sure to inquire about any additional fees for their services so you’re well prepared.
Take Advantage of 1031 Exchanges With 1031 Crowdfunding
A qualified intermediary is critical to the success of your 1031 exchange. Once you’ve found a QI to help you through the transaction, you can get the ball rolling on your new property. At 1031 Crowdfunding, while we don’t offer QI services, we do offer an extensive online marketplace of 1031 exchange opportunities to help you identify new properties. Our platform contains many resources that can help you streamline the exchange process, find an investment that suits your needs, and empower you to gain the earning potential you seek.
Our team of professionals is ready to support you throughout the 1031 exchange process and help you make informed decisions. Register for an account today to learn more about our services and how we can assist you in complying with 1031 exchange terms.
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