As a real estate investor, you may at some point want to use a 1031 exchange to defer tax liability on the sale of an investment property by using the sale's proceeds to acquire a new property. If you do, you'll need a qualified intermediary.
Choosing a qualified intermediary, sometimes referred to as an exchange accommodator or facilitator, is a crucial part of completing a 1031 exchange. The Internal Revenue Service has very specific rules one must follow to successfully defer their capital gains tax through a 1031, and making even the slightest error could cause you to pay the taxes you were trying to avoid. A qualified intermediary ensures that all of these rules are followed and requirements are met to successfully complete the exchange.
What does a qualified intermediary do in a 1031 exchange?
Under treasury regulations, using a qualified intermediary is a requirement for deferring capital gains taxes through section 1031 exchanges. During the sale of real estate you want to exchange, you're not allowed to receive the proceeds of the sale directly. Instead, the property is sold through a qualified intermediary.
The intermediary sells the property on your behalf and receives the funds from the sale. If you receive any money from the sale directly, you will have to pay capital gains taxes on that amount.
Once the sale is complete, the intermediary holds the funds in an escrow account with their financial institution. They later use these funds to purchase the replacement property and transfer the deed to you to complete the exchange. If there are any proceeds remaining after purchasing the replacement property, the qualified intermediary will return those funds to you.
Who can act as a facilitator in a 1031 exchange?
There aren't any licensing or educational requirements necessary to be a qualified intermediary. To be considered qualified under Internal Revenue Code (IRC) section 1031, you cannot be an intermediary for yourself, nor can anyone related to you or anyone who has acted as your agent in the previous two years. The following are examples of a qualified agent:
- Investment broker.
- Real estate agent.
Anyone not allowed to be your qualified intermediary is referred to as a disqualified person.Using any disqualified person as your intermediary will jeopardize your 1031 exchange.
How do you find a qualified intermediary?
While you can technically hire anyone who's not a disqualified person to be your qualified intermediary, it's highly recommended that you use a professional qualified intermediary service experienced in tax-deferred exchanges and knowledgeable with IRC section 1031.
Other professionals involved in the exchange may be able to recommend an intermediary they have worked with before if they are comfortable with their knowledge in the process. A CPA with 1031 exchange experience, a real estate attorney, or a reputable title company can be good sources for referrals to qualified intermediary services.
Another excellent source for finding a knowledgeable qualified intermediary is through the Federation of Exchange Accommodators (FEA). The FEA has a qualified intermediary certification program with a directory of its members that are Certified Exchange Specialists. To receive certification, exchange accommodators must:
- Have at least three years of equivalent full-time work experience at a qualified intermediary company.
- Receive a minimum of 20 hours of continued education every two years.
What to look for in a 1031 exchange accommodator
Choosing the right qualified intermediary is an important decision to ensure your exchange goes as smoothly as possible. Doing thorough due diligence on any qualified intermediary you're considering hiring will ensure you'll be working with somebody capable of properly adhering to the IRC section 1031.
Size of the company
Patrick Goeglein with American Accommodators says you should ask about the size of a company's team of intermediaries. "Make sure there are adequate backup personnel available to facilitate your exchange," he says. "Many QI companies are one- or two-man offices. When there is a family or business emergency, an exchanger (seller) is left out in the cold with no backup support when something happens to the QI. This has devastating consequences for the exchanger."
As with any internal revenue code, section 1031 requires the steps to be performed precisely and in order. Your qualified intermediary suddenly not being available during a crucial point in the transaction could not only be an inconvenience but may put the entire transaction at risk.
Financial and liability protection
Goeglein also stresses the importance of asking what financial and liability protections the qualified intermediary company has in place. "Make sure the E&O and fidelity insurance is in place," he says.
E&O refers to errors and omission insurance. This is an insurance policy the exchange company should have in place to protect the seller and the qualified intermediary from any errors or omissions performed by the intermediary.
The fidelity insurance refers to a bond that covers any financial losses incurred from any fraud on the part of anyone working for the exchange company.
Josh Sandberg, a CPA with Sandberg and Associates, says you also want to find out how the qualified intermediary handles investors' funds. "Some intermediaries may invest the seller's funds into something like a short-term CD to earn extra interest," he says.
Since qualified intermediaries are mostly unregulated, so there's very little oversight to monitor how funds are handled.
"If the intermediary is investing the sellers' funds, they may start using exchange funds from one deal to purchase the replacement property on another deal," Sandberg explains. "You don't want to end up in the middle of a rob Peter to pay Paul kind of situation."
If your exchange transaction involves several million dollars, you likely don't want to hire a 1031 exchange service that has only exchanged a handful of single-family rentals or duplexes. With higher dollar amounts comes greater scrutiny from the IRS as well as a lot more at stake if you end up paying capital gains taxes on the sale.
Sandberg suggests asking qualified intermediaries about the types of deals they've worked on, the size of the exchanges they've done, and the number of transactions they've completed. "You don't want to have your intermediary learning how to handle a situation like yours at your expense," he explains.
Finding a qualified intermediary with a good reputation will help in making sure you're working with a company that will give your exchange the proper attention and will return your phone calls when you need to reach them. Knowledge and experience are crucial traits for an exchange accommodator to have, but those traits mean very little if they're not handling their transactions properly.
The process of working with a qualified intermediary
Ideally, the qualified intermediary you choose should be involved in the process as soon as possible. Goeglein suggests talking to an intermediary before you even list your property for sale. "Many people have ideas that won't work with an exchange and need to know before they are under contract," he says.
A seller can make mistakes early on that can cause problems for the exchange. Consulting with a professional is always a good idea before making decisions regarding your real estate investments.
Here are the basic steps involved when working with a qualified intermediary during your 1031 exchange:
- Have language added to the real estate purchase agreement that allows the purchase agreement to be transferred to the qualified intermediary at closing.
- The qualified intermediary prepares the required exchange documents with instructions to the title or escrow company.
- An exchange agreement between you and the qualified intermediary is signed, allowing him to facilitate the 1031 exchange.
- At closing, the relinquished property is transferred from you to the intermediary and simultaneously transferred from the qualified intermediary to the buyer.
- The qualified intermediary then receives the net proceeds from the sale, which are then placed in escrow.
- You must identify a replacement property within 45 days of the sale and inform the qualified intermediary, in writing, of the identified property.
- Within 180 days of the sale, the qualified intermediary will purchase the replacement property with the funds from the sale of the relinquished property.
- The intermediary then transfers the deed to you, completing the exchange transaction.
When it comes down to it, you should work with a qualified intermediary that you are comfortable with. This is somebody you're trusting to be responsible for a significant amount of your money and to complete a transaction that will have a major financial impact on you and your business.
Become A Mogul Today
Real estate is one of the most reliable and powerful ways to grow your wealth - but deciding where to start can be paralyzing.
That's why we launched Mogul, a breakthrough service designed to help you take advantage of this critical asset class. Mogul members receive investing alerts, tax optimization strategies, and access to exclusive events and webinars. Past alerts have included investments with projected IRRs (internal rates of return) of 16.1%, 19.4%, even 23.9%.