What is a Qualified Intermediary?

Investing can be a daunting task, especially when it comes to real estate.  However, those who invest in real estate and are aware of the many tax benefits real estate can provide can reap incredible financial benefits.  One of the most pivotal sections in the tax code for real estate investors is section 1031.  As you might already know, section 1031 allows for like-kind property exchanges, meaning you can sell a property and roll your investment into another property without paying taxes on your investment gains.  

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To make your 1031 exchange a reality, you’ll need to fill a very important role - one that’s very niche, and specific to this particular type of exchange - a qualified intermediary (QI).  Qualified intermediaries are a pivotal piece of the 1031 exchange puzzle.  A great QI will ensure the success of your 1031 exchange, but having a bad QI may land you in some hot water with the IRS.

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What is a 1031 Exchange?

Before we delve into exactly what a qualified intermediary is, it’s important to know exactly what a 1031 exchange is.  For those unaware, a 1031 exchange (named after section 1031 of the Internal Revenue Code, or IRC) allows you to defer paying capital gains taxes when you sell an investment or business property.  

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This can only be done so long as the proceeds are reinvested into a similar property of equal or greater value and all of the rules outlined in section 1031 are abided by, of which there are many.  A qualified intermediary will work in conjunction with you and your real estate team in this particular type of real estate transaction to ensure that your transaction is done and documented properly.

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This is certainly a very succinct explanation of a 1031 exchange.  If you’d like to learn more about exactly how 1031 exchanges work and the rules that govern them, be sure to check our full-length article that delves into everything you need to know about the 1031 exchange.

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What is a Qualified Intermediary in Terms of a 1031 Exchange?

A QI is an independent third party that manages the exchange process.  They are tasked with ensuring that the exchange abides by the strict guidelines set forth by the IRS.  The most crucial role that a QI plays in the 1031 exchange process is facilitating both the sale of the existing property and the purchase of the replacement property, ensuring that the taxpayer does not have control of the sale proceeds at any point in time during the exchange.  

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This is important because according to the Internal Revenue Code (IRC), the taxpayer cannot have “constructive receipt” - they cannot receive or have control of the sale proceeds.  Constructive receipt of income is when you effectively receive income but do not have the funds in your account. If the taxpayer receives or gains control of the sale proceeds at any point in the exchange process, they have constructive receipt, and the 1031 exchange is null and void.  This means that the taxpayer will be responsible for paying the capital gains taxes on the property that they sold.  

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An example of constructive receipt that you might encounter while doing a 1031 exchange is if you, a family member, or a friend were to take possession of a check payment made at closing.  Even if that check isn’t deposited into your account or your friend/family member’s account, in the eyes of the IRS, you have constructive receipt of that payment, meaning your 1031 exchange would be null and void.  Instead, all payments must be routed directly to your QI, completely cutting you and your associates out of the picture.  

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Since the QI is holding your funds in between property escrows while the transaction takes place, that means it’s also important to have a reputable, trusted QI.  After all, you’ll be entrusting them with hundreds of thousands, or potentially even millions of dollars of your money.  

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Who Can Be a Qualified Intermediary?

Unfortunately, not just anyone can be a qualified intermediary.  They need to be truly disconnected from both your personal life and business operations.  Fortunately for us, the IRS has set forth a very strict and clear ruleset as to who can and cannot be a qualified intermediary for you.  

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Impartiality and Independence

Your qualified intermediary must be an independent third party. This means that they can’t have a close relationship with the taxpayer in terms of their personal or business lives.  To help determine whether or not someone has a close connection with you, they have laid out a set of criteria that would disqualify someone from meeting the “independence” criteria.  

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A disqualified person is someone who has acted as the taxpayer’s agent within the two years preceding the 1031 exchange, which would include (but are not limited to):

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• Employees
• Attorneys
• Accountants
• Relatives
• Real Estate Agents
• Real Estate Brokers
• Friends

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So, you cannot use the people that you traditionally trust with your finances, like your attorney and accountant, as your qualified intermediary, which of course, makes first-time users of the 1031 exchange a bit cautious.  

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Qualified Intermediary as a Specialized Role

When working with a specialized QI firm, like Deferred, there are considerable financial and tax benefits.  Firms like ours don’t just securely hold and manage the exchange funds, but we’re able to provide you with expert guidance to ensure that the transaction is structured correctly, according to IRS regulations.  Our extensive experience in 1031 exchanges will help you navigate the complexities of the tax code efficiently and at a lower cost than a non-specialized firm.

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How is a Qualified Intermediary Different from the Rest of the Transaction Team?

Although there are quite a few parties involved in a 1031 exchange, such as attorneys, accountants, financial advisors, and real estate agents, the qualified intermediary holds a very unique role.  Understanding the differences between your QI and the other parties involved in your transaction will ensure that you have a smooth and compliant exchange.

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The Role and Responsibilities of a Qualified Intermediary

The primary role of your qualified intermediary is facilitating the 1031 exchange in accordance with all IRS regulations.  This involves a few specific duties that are unique to your qualified intermediary.

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The first of these responsibilities is facilitating the exchange itself.  In a 1031 exchange, the qualified intermediary will handle both the sale of the existing property and the purchase of the new property so that the taxpayer does not mistakenly receive control of the sale proceeds, holding those proceeds in a secure account.  This is done in an effort to prevent the taxpayer from having constructive receipt of the funds. 

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A qualified intermediary will also be responsible for ensuring your transaction is in compliance with IRS timeline regulations.  When it comes to 1031 exchanges, there are very specific timeline-related guidelines that must be adhered to.  Your QI will be responsible for all documentation and adherence to the 45-day identification period and the 180-day completion period.  

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They will be a key player in ensuring that your transactions take place in a timely fashion and everything moves according to schedule.  Although there’s a good chance that your real estate agent and attorney will be involved in the scheduling/coordinating of the transactions to a certain degree, your QI plays a much larger role in ensuring that the structure of the transaction, and the documentation, meet the requirements for a successful 1031 exchange.  

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Expertise in 1031 Exchanges

Your QI will also provide the expertise needed for a smooth transaction.  Although your attorney, accountant, or real estate agent may have dealt with a 1031 exchange or two in the past, chances are that they’re not experts in the field.  At the end of the day, a 1031 exchange is a very niche and tedious type of transaction that requires the care of an expert.

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Unfortunately, most tax, legal, and real estate professionals are not experts in 1031 exchanges. While they could help you, they often would need to research each step of the process and create documents from scratch, which could lead to a much larger bill at the end of the process. 

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Specialized firms, like Deferred, provide their clients with the expertise and resources they need to successfully navigate the complex nature of a 1031 exchange.  Additionally, if an IRS audit arises, your qualified intermediary more than likely has dealt with these matters before and can provide you with all of the documentation they need.  

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What Does a Qualified Intermediary Do?

Although we’ve covered much of what a qualified intermediary does above, there are a couple of different ways to perform a like-kind exchange, and the role of the Qualified Intermediary can be different for each case.  Below, we’ve laid out exactly what a qualified intermediary does in each situation:

Qualified Intermediary’s Role in a Forward Exchange

A forward exchange is what most people refer to as a 1031 exchange since this type of exchange is the most common form of 1031 exchange.  This means that in a forward exchange, your qualified intermediary will do everything that we laid out above.  They will:

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• Ensure that the transactions abide by all IRS rules and regulations
• Ensure proper documentation and adherence to timelines
• Hold funds to avoid constructive receipt by the exchanger
• Provide the niche expertise needed to properly complete the transaction
• If needed, provide audit support and send documentation to the IRS

Qualified Intermediary’s Role in a Reverse Exchange

Reverse exchanges are a bit more complicated than forward exchanges.  A reverse 1031 exchange is a real estate transaction where the taxpayer acquires the replacement property before selling the relinquished property. This strategy is often used when a desirable replacement property becomes available before the taxpayer can sell their existing property.  This, of course, complicates things a bit more for both yourself and your qualified intermediary.

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In this situation, your QI will do everything that they do in a forward exchange, in addition to acting as the Exchange Accommodation Titleholder (EAT).  The EAT is a person or entity that acquires and holds the title to the replacement property on behalf of the taxpayer. This "parking arrangement" is crucial for compliance with IRS regulations.

The QI's key responsibilities in a reverse exchange include:

• Acquiring the replacement property
• Holding title to the replacement property during the exchange period
• Facilitating the sale of the relinquished property once identified
• Transferring the replacement property to the taxpayer upon completion
• Ensuring compliance with strict IRS timelines (45 days for identification, 180 days for completion - both of these are measured from the date of acquisition of the replacement property)

Unlike in a forward exchange, where the QI primarily holds proceeds from the sale, in a reverse exchange, the QI takes on a more active role in property acquisition and management. This arrangement allows taxpayers to secure desired properties while still benefiting from the tax deferral advantages of a 1031 exchange.

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How Can You Find a Qualified Intermediary?

Given how important a qualified intermediary is to the success of your 1031 exchange, finding a great one is key.  However, given how specialized the role is, finding a great QI can be difficult sometimes, especially when you’re working in secondary or tertiary real estate markets.  Fortunately for you, though, you can rest assured knowing that there are a few tried and true ways to find a qualified intermediary, no matter where you are in the country.

Deferred.com

Lastly, another great way to find a qualified intermediary for your 1031 exchange is through Deferred!  We are equipped to act as your qualified intermediary, and we also have a handy tool to help you find qualified intermediaries if you’d prefer to work with someone else!  We have a rolodex of qualified intermediaries vetted and verified for every state in the US that’s free to access.

Referrals and Recommendations

One of the best ways to find any specialized person/company, whether you’re looking for a plumber or a qualified intermediary, is through referrals.  Although your friends or associates in the real estate industry cannot act as your qualified intermediary, that doesn’t mean that they can’t recommend one for you!  Likewise, if you don’t have any friends/associates that have done 1031 exchanges, your financial advisor, attorney, or accountant may be a great place to seek out referrals too, especially if they specialize in real estate-related services!

Industry Associations and Professional Memberships

As with any industry, there are industry associations for qualified intermediaries, with the most prominent being the Federation of Exchange Accommodators (FEA).  QIs that are a part of this organization often adhere to the highest standards of practice.  Additionally, their membership to such an organization shows a high level of commitment to maintaining industry standards and staying up-to-date with the latest changes in regulation and best practices.  When you find a QI, you can always look them up on the FEA website, or use their handy tool to find QIs near you!

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What Should You Look For in a Qualified Intermediary?

Once you find what you think might be a suitable qualified intermediary for your 1031 exchange, you’re probably going to want to do a bit of research on their background.  Below, we’ve outlined some things you’ll probably want to look for to find a great QI for your transaction:

Experience and Expertise

When you’re in the market for a great QI, you’re probably going to want to partner with someone who has years (preferably decades) of experience under their belt.  Although there may be a new kid on the block offering their services at a discount, it’s important to remember that nine times out of ten, you get what you pay for.  The amount of money you save using their services is a drop in the bucket compared to the money you can lose from an exchange that falls out of compliance.

Compliance With IRS Regulation

Your qualified intermediary should have a proven track record of successfully facilitating 1031 exchanges.  When interviewing prospective QIs, don’t be scared to throw a couple of regulatory questions their way and see how they answer them.  If their answers give you any concerns with regard to their expertise or how they run their business, it might be best to move on to another QI.

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Some questions you should consider asking a prospective QI around IRS compliance are:

• How do you ensure compliance with IRS deadlines, such as the 45-day identification and the 180-day exchange period?
• Can you describe the process you follow to prevent constructive receipt of funds by the taxpayer?
• How do you handle the documentation required for the exchange, and what records do you maintain to ensure IRS compliance?
• Do you have experience dealing with IRS audits related to 1031 exchanges? If so, how do you assist clients in these situations?

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Security of Funds

Remember, your QI is not like your attorney - they’re going to act as a bank of sorts, holding your money for an extended period of time.  Be sure to ask them about how they hold their funds.  Great QIs will hold funds at trusted financial institutions in separate accounts for each exchange, with appropriate levels of insurance coverage.  At the end of the day, you need to find someone who will be a responsible steward of your money!

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Some questions that you might want to ask a prospective QI regarding the security of funds are:

• Are my funds held in segregated accounts or commingled with other exchange funds?
• Are my funds covered by FDIC Insurance?
• Do you invest my funds while I'm in the exchange process?
• Can you provide information on the financial institutions where the funds will be held?
• What measures do you have in place to protect my funds from unauthorized access or fraud?

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Great Referrals

Once you find a prospective QI, you can always ask them to provide you with a list of a few clients who would be willing to hop on a quick call and attest to their work as a QI.  Chances are they will cherry-pick these clients, so when you talk to them, if they have anything negative to say, you may want to consider using a different QI.

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Wrapping Things Up: Choosing the Right Qualified Intermediary

Selecting the right Qualified Intermediary is one of the most important decisions you’ll make in the 1031 exchange process. The QI’s role is not just administrative; it’s pivotal in ensuring that the transaction complies with IRS regulations and that the taxpayer successfully defers capital gains taxes. By carefully considering the factors outlined above and conducting thorough due diligence, you can choose a QI who will guide you through the exchange process with confidence and peace of mind.

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By working with Deferred or one of our partner QIs, you can rest assured knowing that you’re in business with a professional QI that has years of experience and knowledge under their belt.  Both our in-house QIs, as well as our partner QIs, are held to the highest standards and have a myriad of successful 1031 transactions under our belts.  We’ve been a part of 1031 exchanges, from the simplest of forward exchanges to the most complex construction exchanges and everything in between.