A qualified intermediary (QI) is required for all 1031 exchanges. Given the importance of the QI in an exchange, it is imperative for real estate investors to identify one they can trust and rely on. Achieving this, however, can be difficult – how does an investor know whether a particular QI is credible? Here is a brief tutorial on how to select a reputable QI for a 1031 exchange.

What is a QI?

A QI, also known as an accommodator, is an individual or entity that facilitates a 1031, or like-kind, exchange as outlined in Internal Revenue Code (IRC) Section 1031. The role of a QI is defined in the Federal Code as follows:

A qualified intermediary is a person who -

(A) Is not the taxpayer or a disqualified person, 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. (26 CFR § 1.1031(k)-1)

An individual does not need to meet any eligibility requirements or acquire a license or certificate to become a QI. However, the Internal Revenue Service (IRS) does stipulate that anyone who is related to the exchanger or has had a financial relationship with the exchanger – such as an employee, an attorney, an accountant, an investment banker or broker, or a real estate agent or broker – within the two years prior to the sale of the relinquished property is disqualified from acting as the exchanger’s QI.

Why is having a QI important in a 1031 Exchange?

Every 1031 exchanger must identify a QI and enter into a written contract prior to closing on the relinquished property. Once selected, the QI has three primary responsibilities: prepare exchange documents, exchange the properties, and hold and release the exchange funds.

Preparing Exchange Documents

Throughout the exchange, the QI prepares and maintains all relevant documentation, including escrow instructions for all parties involved in the transaction.

Exchanging Properties

A 1031 exchange requires the QI to acquire the relinquished property from the exchanger, transfer the relinquished property to the buyer, acquire the replacement property from the seller, and transfer the replacement property to the exchanger. Although the QI also transfers the title, the QI does not actually have to be part of the title chain. 

Holding and Releasing Exchange Funds

For an exchanger to defer capital gains, all proceeds from the sale of the relinquished property must be held with the QI; any proceeds held by the exchanger are taxable. Therefore, the QI must take control of the proceeds from the sale of the relinquished property and place them in a separate account, where they are held until the purchase of the replacement property.

Exchangers must meet two key deadlines for the exchange to be valid. The first comes at the end of the identification period. Within 45 calendar days of the transfer of the relinquished property, the exchanger must identify the replacement property to be acquired. The second comes at the end of the exchange period. The exchanger must receive the replacement property within 180 calendar days of the transfer of the relinquished property. These deadlines are strict and cannot be extended even if the 45th or 180th day falls on a Saturday, Sunday, or legal holiday.

What should investors consider when choosing a QI?

Since a QI is not required to have a license, investors should conduct due diligence to ensure they select an individual who can properly manage the 1031 exchange. Unfortunately, the IRS does not excuse any errors committed by a QI, and, as a result, investors may be required to pay taxes on the exchange due to these mistakes. Here are a few things investors should consider when selecting a QI.

State Regulations

While the federal government does not regulate QIs, some states have enacted legislation that does. For example, California, Colorado, Connecticut, Idaho, Maine, Nevada, Oregon, Virginia, and Washington have all passed laws overseeing the industry. Many of these states have requirements for licensing and registration, separate escrow accounts, fidelity or surety bond amounts, and error-and-omission insurance policy amounts.

Federation of Exchange Accommodators

The Federation of Exchange Accommodators (FEA) is a national trade association that represents professionals who conduct like-kind exchanges under IRC Section1031. The FEA’s mission is to support, preserve, and advance 1031 exchanges and the QI industry. Association members are required to abide by the FEA’s Code of Ethics and Conduct.

In addition, the FEA offers a program that confers the designation of Certified Exchange Specialist® (CES) upon individuals who meet specific work-experience criteria and pass an examination on 1031 exchange laws and procedures. Holders of this certificate must pass the CES exam and meet continuing education requirements. The “designation demonstrates to taxpayers considering a 1031 exchange that the professional they have chosen possesses a certain level of experience and knowledge.”

Knowledge and Experience

As mentioned, a QI’s mistake in a 1031 exchange can result in a taxable transaction. Investors who are in the process of selecting an accommodator should review each individual’s qualifications – including knowledge and experience in the industry – before making a final decision. Investors should inquire whether the individual is full- or part-time; how many transactions and how much in value the individual has facilitated. Additionally, it is important to know whether the individual has any failed transactions and, if so, why.

Knowledge about 1031 exchanges is critical. Not only should potential QIs know the basics, but they should understand the ins and outs of the 1031 exchange process. For example, QIs should know what qualifies as a like-kind property. Likewise, they should know about Delaware Statutory Trusts (DSTs), one of the most commonly overlooked alternative 1031 exchange solutions. Unfortunately, many QIs are not familiar with DSTs. Finding a knowledgeable and experienced QI is crucial for investors who want to successfully defer capital gains while continuing to meet their overall financial objectives.

How should an investor go about selecting a QI?

To find a QI in good standing, investors should seek referrals. Word of mouth can be a great way to find a credible QI. Investors can ask for a referral from a certified public accountant (CPA) with 1031 exchange experience, a real estate attorney, a reputable title company, or even the other party in the exchange.

When vetting a potential QI, investors need to ask questions that will reveal the individual’s depth of knowledge and experience – beyond just the basics. For instance, the FAE requires potential QIs to work full-time for at least three years before they can even sit for the CES exam. Three years is a good baseline to start from when judging a QI’s experience; five to 10 years is a solid amount.

Finding a QI is one of the most critical parts of a 1031 exchange, as the transaction cannot be completed without one. Investors must ensure that their QI is experienced and thoroughly understands the various tax codes involved. Investors also need to ensure that the QI has not been financially connected to them within the past two years and is not a relative, employee, or agent. The IRS does not take these factors lightly; failure to comply with what is presented here may lead to hefty penalty fees – or the IRS may prohibit the exchange from occurring altogether.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

• There is no guarantee that any strategy will be successful or achieve investment objectives;
• Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
• Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
• Potential for foreclosure – All financed real estate investments have potential for foreclosure;
• Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
• Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
• Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits