A 1031 Exchange is a complex transaction with many rules that investors must follow in order to achieve the full tax deferral benefits and getting it wrong can have significant financial ramifications for the taxpayer. For this reason, it is always a best practice to get support in the transaction from an individual known as a Qualified Intermediary or QI for short.
In this article, we are going to describe what a Qualified Intermediary is, how they support a 1031 Exchange Transaction, when they are needed, and how to find one. By the end, readers will have a thorough understanding of the Qualified Intermediary role and will be able to incorporate this knowledge into their 1031 Exchange due diligence process.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. As part of this effort, we have a significant amount of experience working with individuals to place their 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about how we can help facilitate a 1031 Exchange, click here.
What is a 1031 Exchange?
In order to understand the role of a Qualified Intermediary, it is first necessary to understand what a 1031 Exchange transaction is.
A 1031 Exchange – sometimes called a Like Kind Exchange – is a real estate transaction, sanctioned by section 1031 of the Internal Revenue Code (”tax code”), that allows investors to defer capital gains tax liability on the profitable sale of an investment property. In order to receive full tax deferral, there are a number of rules that investors must follow when completing the transaction. For example (the list is not exhaustive):
- Investors must identify, in writing, a replacement property within 45 days of the sale of their asset (the “relinquished property).
- Investors must complete the purchase of the replacement property within 180 days of the sale of the relinquished property.
- Both properties must be held for productive use in a business or trade or for investment
- 100% of the proceeds from the relinquished property must be reinvested into the replacement property
Violating one of the rules in a 1031 Exchange can have significant financial consequences in the sense that it may nullify some or all of the tax deferral. For example, if the investor does not reinvest 100% of the sales proceeds into the new property, any funds not invested (and presumed received as cash by the exchanger) are classified as “boot” and they become taxable.
So, to ensure compliance with all of the rules in a 1031 Exchange, it is a general best practice for investors to partner with a Qualified Intermediary.
What is a Qualified Intermediary?
A Qualified Intermediary, sometimes referred to as an Accommodator or Facilitator, is an individual, entity, or financial institution, that assists in the facilitation of a 1031 Exchange.
More specifically, a Qualified Intermediary is further defined in 26 CFR § 1.1031(k)-1(g)(4), which states that a Qualified Intermediary is a person who:
(A) Is not the taxpayer or a disqualified person (as defined in paragraph (k) of this section), and
(B) Enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.
Given the definition above, it is clear that the Qualified Intermediary plays a critically important role in a 1031 Exchange. In the next section, their role is defined in more detail.
What Does a Qualified Intermediary Do In a 1031 Exchange?
The short answer is that a Qualified Intermediary performs a number of activities to make sure a 1031 Exchange runs smoothly and in accordance with the rules established by the Internal Revenue Service (IRS). The root of their job is to ensure that the taxpayer is able to achieve full tax deferral in the transaction.
More specifically, a Qualified Intermediary may:
- Work with the taxpayer’s attorney, CPA, or other tax advisor to ensure that the rules of the exchange are understood and to set expectations for timing.’
- Prepare, review, or execute 1031 Exchange documents (the Exchange Agreement, Assignment Agreements, Notice of Assignment or Security of Funds Instruments).
- Oversee or execute transaction closings to ensure compliance with rules
- Facilitate the sale of the relinquished property on behalf of the taxpayer and purchase the replacement property from the seller
- Create a qualified escrow account to hold exchange proceeds until they are needed to purchase the replacement property.
- Act as a trusted advisor throughout the duration of the exchange process
Again, given their specific duties, the main priority of a Qualified Intermediary is to work with their client(s) to ensure an orderly, smooth transaction that adheres to all 1031 Exchange rules.
When Is a Qualified Intermediary Needed?
There are two ways to think about when a Qualified Intermediary is needed. The first is that a QI is needed whenever an investor is considering entering into a 1031 Exchange transaction. Secondly, a qualified intermediary should be hired at, or as close to the beginning, of the 1031 Exchange process as possible.
When both of these guidelines are followed, investors have maximized their chance to ensure that all rules are followed and that the transaction qualifies for full tax deferral.
Finding and Selecting a Qualified Intermediary
Given the importance of a qualified intermediary in the transaction, the decision as to which Qualified Intermediary to use is not one that should be taken lightly.
Finding a Qualified Intermediary that provides 1031 Exchange Services is relatively simple. They can be found through referrals from other investors or simple internet searches.
If finding a Qualified Intermediary is relatively simple, selecting one can be a bit trickier. To find a suitable fit, investors should review several areas of a QI’s qualifications:
- Experience: Has the intermediary been in business for some time? And, do they have the transaction reps for the type of exchange that the investor wishes to pursue? For example, the rules and requirements for a typical delayed exchange are very different from those in a reverse exchange.
- Reputation: Does the QI have a good reputation in the local market for service and expertise?
- Trade Groups and Certifications: To burnish their reputation, the best Qualified Intermediaries/Exchange Facilitators are members of their industry trade groups like the Federation of Exchange Accommodators.
- Financial Resources: A big portion of a Qualified Intermediary’s job is to hold funds for their client(s) for the duration of the transaction. To do so safely, the intermediary must have the financial resources and discipline to safely escrow investor funds. While rare, it is not unheard of for a Qualified Intermediary to go out of business and leave investors in a bad spot.
So, the broader point is that investors should use all available means to find a Qualified Intermediary, but then be very diligent and thorough before selecting one to work with.
Qualified Intermediaries and Private Equity Investments
Any individual investor can complete a 1031 Exchange transaction, but finding a suitable replacement property within a relatively short timeframe can represent a real challenge. For this reason, many choose to work with a private equity firm that has the relationships, resources, and property inventory to make finding a replacement property much easier.
In a transaction that assists investors in placing their 1031 property Exchange proceeds, the private equity firm and Qualified Intermediary work hand in hand to complete the transaction.
Summary of Qualified Intermediaries in 1031 Exchanges
A 1031 Exchange, so named after IRC Section 1031, is a type of real estate transaction that allows investors to defer capital gains taxes on the profitable sale of a real property as long as they reinvest the proceeds into a “like kind property.”
To achieve full tax deferral, there are a number of rules that investors must follow. To ensure they are followed, it is a best practice to work with a Qualified Intermediary.
A Qualified Intermediary is an individual or entity who works investors to facilitate a 1031 Exchange and ensure adherence to the rules outlined in Internal Revenue Code section 1031.
Among other things, a Qualified Intermediary’s role is to ensure that all rules are followed, to prepare the paperwork – ensuring there are no omissions, and to advise their client(s) on the transaction.
Qualified Intermediaries can be found through referrals or internet searches and should be evaluated based on their experience, expertise, and financial resources.
Interested In Learning More?
First National Realty Partners is one of the leading private equity commercial real estate investment firms in the United States. We leverage decades of expertise to find world-class, multi-tenanted assets available below intrinsic value. We seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our investment opportunities, contact FNRP at (800) 605-4966 or info@fnrpusa.com.
