So you’ve decided to participate in an Internal Revenue Code (IRC) Sec. 1031 exchange. Qualified intermediaries (QIs) can make or break your exchange, so hiring the right one is crucial. Here’s what you need to know.
Using a 1031 Exchange
Sec. 1031 allows taxpayers to exchange business or investment property for property of a like kind without recognizing any gain or loss until they sell the replacement property. The majority of these transactions are deferred exchanges — the seller has 45 days after selling a property to identify a like-kind property and 180 days to invest the sale proceeds in that property.
However, the IRC prohibits the seller from gaining actual or constructive receipt of the sale proceeds. In a deferred exchange, the parties rely on a QI to hold the proceeds until they’re transferred to acquire a replacement property.
Heeding the IRS Warning
Unfortunately, many states simply don’t pay much attention to the QI industry. Anyone can call themselves a QI and start administering Sec. 1031 exchanges. In fact, numerous states don’t require QIs to be bonded or insured or carry a minimum equity capitalization.
Problems with QIs can end up disqualifying the transaction for the gain deferral. Years ago, after several high-profile incidents involving QIs that declared bankruptcy or otherwise were unable to fulfill their contractual obligations, the IRS warned real estate professionals and investors to exercise caution when selecting QIs.
Researching Your QI
To protect your interests, here are some areas to discuss with a proposed QI:
Wealth management and business objectives. Check that your QI has a thorough knowledge of the complexity of Sec. 1031 exchanges and their interplay with other tax laws. Can the QI work with you to help you achieve your wealth management and business objectives? Some QI firms lack the tax expertise to execute more complex exchange structures, and just one mistake in legal documentation could disqualify your Sec. 1031 exchange. Confirm that the QI can handle all of your Sec. 1031 exchange needs.
Client funds. Find out how the QI handles its clients’ funds, including the steps it takes to protect funds and ensure liquidity. Will you have any influence on how the QI invests the funds? Find out if the QI “commingles” or segregates funds. The IRS considers commingled funds to be held as a loan to the QI for tax purposes, and considers clients general creditors. However, while the IRS considers segregated funds as a loan to the QI, they may not become part of the general asset pool in the event of the QI’s bankruptcy.
Some QIs allow you to decide where the funds are deposited and in which types of accounts. Either way, insist that the QI disclose how it holds funds and earns revenue.
Internal controls. Inquire about the QI’s fraud prevention efforts, including internal controls, internal audits and employee screening. Choose a QI that carries sufficient Errors and Omissions (E&O) insurance coverage to protect against loss from human error.
Fee schedule. Make sure you fully understand the QI’s fee schedule from the beginning. It could include transaction fees, hourly exchange consulting fees and interest sharing arrangements.
Completing the due diligence suggested above gives you a better chance of hiring a QI that’s truly experienced and can help you through the Sec. 1031 process. In addition, it’s a good idea to consult your real estate and tax advisors to help you with the Sec. 1031 process or provide you with QI recommendations, if you’re uncertain about whom to hire.