January 27, 2022
Peter
Peter Marzo

Real estate ownership can have many complex elements to it including management, maintenance, leasing, budgeting, bookkeeping, etc.  Another very important element is what is a 1031 exchange and the long-term benefits they offer.  One might wonder how the exchange process works and how to go about accomplishing a successful exchange.  Arguably, the most crucial component of a 1031 exchange is the 1031 Exchange Accommodator or Qualified Intermediary (QI). 

In this article we will touch on many important topics including:

            ·         Who is a Qualified Intermediary (QI)?
            ·         What role does the Qualified Intermediary (QI) play in an exchange?
            ·         What Steps are involved in a 1031 Exchange?
            ·         Suggested Questions for Your Qualified Intermediary (QI)?

 

Who is a Qualified Intermediary (QI)?
A Qualified Intermediary (QI), also know as the exchange accommodator or exchange facilitator is an independent entity that is not the investor, an agent of the investor, or a related party to the investor that enters into a written agreement with the investor to complete exchange transactions on behalf of the investors for the purpose of adhering to 1031 exchange requirements.  In other words, when an investor decides to sell a property and utilize a 1031 exchange, an intermediary must be hired to take physical control of the sale proceeds and hold them in a 1031 escrow account. 

This process ensures the investor does not take physical control of the proceeds and the exchanger can stay in compliance with the IRC tax laws that govern section 1031 of the IRS tax code.  In order to defer paying capital gain and depreciation recapture taxes upon the sale of real property, the taxpayer must avoid both actual receipt and constructive receipt of the final sales proceeds. If an investor were to take receipt of the proceeds from the sale of a property, the exchange would then be null and void and subject to full taxation. 

 

What role does the Qualified Intermediary (QI) play in an exchange?
Think of the Qualified Intermediary (QI) as the glue that holds the buyer and seller together in a 1031 exchange.  Aside from being the heart of the exchange itself, the main function of the QI is to restrict the investor’s access to the sale proceeds upon the sale of the relinquished property and comply with the “safe harbor” rules set out in reg. 1.1031(k)-1(g)(4).  This is done by holding the final sales proceeds of the relinquished property in a qualified escrow account specifically dedicated to holding exchange funds.

For an exchange to qualify for "safe harbor", there must be a written agreement between the taxpayer and intermediary limiting the taxpayer's rights to receive, pledge, borrow or otherwise obtain the funds or property held by the intermediary.  The qualified intermediary does not actually have to be in the chain of title.  In addition, there are no licensing requirements for Intermediaries. Accountants, attorneys and realtors who have served taxpayers in their professional capacities within the prior two years are disqualified from serving as a Qualified Intermediary (QI) for a taxpayer in an exchange.  This is mainly due to a potential conflict of interest upon attempting a 1031 exchange. 

Services offered by a QI include:

  • Holding exchange proceeds in escrow on behalf of the taxpayer;
  • Coordinating with the taxpayer’s attorney and/or tax advisor and providing exchange transaction documents;
  • Preparing exchange documents which including exchange agreements, assignment agreements, notice of assignment, account forms, security of funds instruments (when applicable) and instructions for the closing agents;
  • Providing guidance, information and critical timelines throughout the entire 1031 exchange process;
  • Facilitating the sale of the relinquished property for the buyer and the purchase of the replacement property from the seller;
  • Authorizing the release of 1031 funds to satisfy the close.

 

What Steps are involved in a 1031 Exchange?
Although the process of completing an exchange is relatively simple, the rules are complicated and filled with potential pitfalls.  In a previous article titled, How does a 1031 Exchange Work? we go into further detail on how to commence a 1031 exchange and the timelines involved.  For this article, lets focus on the timelines associated with a Qualified Intermediary (QI).

 

     Step 1: Consult with a Qualified Intermediary (QI) before you decide to sell your property.
Step 2: Prior to closing, (the seller) implement 1031 exchange language into the contract to acknowledge the future use of an exchange. 
Step 3: 45-Day Identification Period: Once the property is sold, the exchanger has 45 calendar days from the day of closing to identify what replacement property(s) will be acquired.
Step 4: 180-Day Closing Period: Once the properties are identified, the exchanger has an additional 135 calendar days (180 days from close) to close on the properties identified in the 45-day ID period.
Step 5: At closing, the QI will release the funds to satisfy the purchase.      

 

Suggested Questions for Your Qualified Intermediary (QI)?
Although the exchange process can complex, some basic due diligence questions you will want to ask your QI are:

  • How long have you been a Qualified Intermediary (QI)?
  • How many 1031 Exchanges have you administered (individual 1031 Exchange officer and 1031 Exchange Qualified Intermediary)?
  • Do you hold clients' 1031 Exchange funds in a segregated Qualified Trust Account or a Qualified Escrow Account?
  • Do you maintain errors and omissions (E&O) insurance coverage to insure against any 1031 Exchange Qualified Intermediary liability?
  • What is the policy limit of your errors and omissions insurance coverage?
  • Do you maintain fidelity bond insurance coverage to insure against employee theft, embezzlement or misappropriation of the 1031 Exchange funds?
  • What is the policy limit of your fidelity bond coverage?
  • Is your fidelity bond coverage “per occurrence” or merely “in aggregate”?
  • Do you provide me copies of your insurance binders so I can verify that your insurance coverage is still in full force and effect?
  • Do your fidelity bond and errors and omissions (E&O) insurance policies cover just the 1031 Exchange Qualified Intermediary, or do they also cover numerous other related entity operations that might diminish the overall protection to me in the event of loss such as title insurance, escrow, etc.?
  • What type of internal processes and internal audit controls have you implemented to protect my 1031 Exchange assets?
  • Will an administrators call me prior to the disbursement of my 1031 Exchange funds to ensure that I want the funds disbursed (as opposed to disbursing when escrow calls)?
  • Where are my 1031 Exchange funds held or invested?

 

Conclusion
It is imperative to choose an experienced Qualified Intermediary (QI) carefully since they are ultimately responsible for keeping your exchange Federally compliant with IRS tax laws and guide you through a successful exchange.  An experienced QI who is familiar with all 1031 exchange laws could be a great addition to your real estate team and potentially save you millions in tax liabilities. 

Remember, there are no federal or state regulation along with no licensing requirements for QIs, so 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 accountants, attorneys and realtors who have served the taxpayer in their professional capacities within the prior two years, or any person related to the taxpayer. 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 in the case the QI were to become bankrupt.

Each QIs operates in a different manor and may make different decisions on how the funds are pooled and invested during the time in which the QI has possession along with different fee structures. Some may charge a flat rate while others may take into consideration 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.

At Marzo Capital Group, we do not offer tax advice or advice directly relating to taxes but can refer you to a list of trusted experts in the 1031 exchange accommodation space.  Further, if you are looking for replacement properties to satisfy an exchange, or have any additional questions about the process, please contact one of our experts.  To learn more about real estate investing and how a 1031 can complement your portfolio, visit the Marzo Capital Group Learning Center

Marzo Capital Group is not a licensed accountant or tax advisor.  Please consult with your CPA before making any investment decisions.


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