Understanding and executing a 1031 exchange for a novice investor may be a daunting task. Experienced investors will review all the steps involved in a 1031 exchange since this transaction may not happen every day. As a real estate investor, you may want to investigate a 1031 tax deferred exchange.
What is a Qualified intermediary Anyway?
By Al DiNicola, AIF®
January 15, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
Besides all the requirements for timing as well as financial technicalities there are additional challenges that may trip up the exchange. In the past few years, the options of utilizing a Delaware Statutory Trust (DST) as an acceptable solution for replacement property has gained in popularity. However, you will need to follow the IRS guidelines and that includes utilizing the services of a Qualified Intermediary or QI.
The IRS has specific regulations that must be followed to successfully carry out the exchange. One of my investors stated she viewed the exchange process like baking from scratch and the importance of following all steps in a specific order. One missed step may cost dearly. The missing step may end up with an unexpected capital gains tax bill. A qualified Intermediary (QI) should be able to ensure all steps are followed.
Understanding the roles of the participants in a 1031 exchange is critically important. The QI is instrumental in the exchange process and without using a QI the exchange may fail. Investors initially will ask “what does the QI do”, “why do I need them”, and “how do find one”.
What is the function of a Qualified Intermediary?
A qualified intermediary (QI), also known as an Accommodator or Facilitator of a 1031 may perform many of the complex and complicated tasks that are required in a 1031 tax deferred exchange.
It is required a QI be a neutral third-party individual or company who takes on the responsibility of handling 1031 exchange proceeds. A qualified intermediary MUST not share any relationship with the taxpayer under the section 1031. An investor cannot use their parents, relatives, children, spouse or as the investor’s CPA advisor, real estate agent, attorney or broker as a qualified intermediary.
The exchange process is facilitated (per IRS rules) by an unrelated party typically a QI. This is to ensure the proper handling of the proceeds according to federal regulations.
It may not be a surprise that there will be taxes due when you sell a property. If you are the taxpayer and you sell a property, the good people at the Internal Revenue Service (IRS) will look for any proceeds received by you (capital gains) as a potential revenue source as taxes on your gain(capital gains taxes). There may be a way to defer taxes on your gain through the use of a 1031 tax deferred exchange. This is a deferral not an elimination. There are very strict rules on who can handle your proceeds. The process involves the QI receiving or obtaining your funds on the closing of your relinquished property and then securely transferring your proceeds (at a future date) for the acquisition of your replacement property. You cannot have access to the funds if you want to successfully execute a 1031 exchange.
QIs responsibilities go beyond simply holding the money. Here are items that may come under the scope of the QI. There will be transaction documentation that will be provided to all parties. This includes communication with the escrow and title agency or in some cases an attorney handling the closings. The IRS regulations are black & white, and QIs will ensure the process complies with the IRS rules. To complete the exchange there may be standard forms as well as additional documents including tax documents.
There may be multiple parties involved with the transaction beside the seller and buyer. Tax advisors, attorneys, financial advisors, financial institutions, and others all need to be contacted and aware of the process and needs for a successful exchange.
The exchange process may be confusing, and the QI should be able to offer guidance with critical information including the deadlines and necessary forms.
What are the qualifications to be a QI?
Each year there are billions of dollars in 1031 exchanges. One of the interesting facts that may surprise many people would be the absence of any licensing, state, or federal regulated standards on a person operating as a Qualified Intermediary business. If there are no standards, how do you qualify? That is a good question. This is an unregulated profession. Real estate brokers and agents need to obtain a state issue real estate license and many who hold a real estate license may be a Realtor. That means they subscribe to a code of ethics and are a member of the National Association of Realtors as well as a member of a state and local association. Financial advisors typically pass licensing test provided by organization and supervised by the securities and exchange commission (SEC) or The Financial Industry Regulatory Authority (FINRA). So, are qualified intermediaries “qualified” for the position and to hold funds? Surprise- anyone who is not the taxpayer can function as a QI.
The opposite of qualified person would be a “disqualified person”. As previously stated, your family members, friends and anyone directly associated with you may not be your QI. What this potentially mean is that anyone may call themselves a QI.
In search of a Qualified Intermediary
Choosing an experienced QI is crucial to avoid costly mistakes. Numerous investors have fallen victim to shady operations or inexperienced QIs that intentionally or unintentionally mismanage funds, leading to substantial financial losses. Choosing a QI can be a daunting task, especially when faced with many options and listing on the internet. Fortunately, there are several ways to seek out and locate competent help.
There are real estate brokers/agents who may be able to suggest a QI based on personal experience. Financial advisors who are involved with 1031 exchanges utilizing Delaware statutory Trust (DST) have engaged with QIs. What you want to avoid is to have a person assisting you as a QI with limited experience and failing to assist you in the strict exchange process. Seek out a QI prior to actually needing their service this will provide you with time to ask the questions, perform due diligence, establish a comfort level and trust. You want to avoid any missteps that may disqualify your exchange.
There is a well-known organization called the Federation of Exchange Accommodators (FEA). Exchange Accommodators may be used interchangeably with Qualified Intermediary. FEA is a recognized organization representing qualified intermediaries. This is a membership organization and FEA seeks to provide education to the members as well as establishing best practices. Similar to the realtor organizations and financial advisors organizations, FEA was created to establish ethical standards of conduct for the QI industry.
Insight into searching for a QI. There are many questions or topics you may discuss with the QI. Here are just a few.
- How funds are managed. The most important item would be following the money. You need to clearly understand where the funds will be deposited once the closing occurs on your relinquished property. The QI needs to understand your expectations and desires. QIs manage funds in different ways. Understand their practices. You may even want to consult a legal counsel if you are new to the 1031 exchange process.
Remember that QIs are not regulated so follow the money or at least know where the money goes and when it will be released. Will you have the ability to provide written consent to the release of your proceeds. Where are your funds being deposited and into what type of account. Is the money in a separate account or lumped in with everyone else’s money. Are the funds invested and gaining interest and to whose benefit. Is there a bond in force for your money.
- References and longevity. The firm should be able to easily provide a recap of the business history, and references just for starters. Some QIs are part of a national firm with multiple locations and others may be local with years of experience. The knowledge base will help with dealing with the occasional complex situation.
- Transparency. You should know who you would be working with or dealing with when you select a QI. One of the first items may be transparency. This may be as simple as who owns the practice and the size of their staff. Are staff members attorneys, CPAs, processors, etc. What safeguards are in place to ensure the exchange process will be completed. Who handles their banking and deposits. What are the fees and service charges.
- Customer service and communication may be the key. Be aware that if you are not prepared ahead of time the service you receive may be affected. If you wait until you are just a few days from closing on your relinquished property there may be little time to assist you. However, under normal situations you should expect prompt and concise communication. Response time will vary based on the agreed method you engage with the QI. Make sure you have your questions answered and maintain a log of responses. QIs should be very clear on their process. You need to avoid any vague responses prior to entering into an agreement. Typically, these agreements are binding once executed and the closing agent on your relinquished property is notified.
The Qualified Intermediary plays a pivotal role in your 1031 exchange. You want a person or firm with extensive knowledge of the process. Plan on spending time researching more than one QI. You don’t want to roll the dice with just any QI. They will be handling your money and just as important securing the successful completion of your 1031 Exchange.
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DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email firstname.lastname@example.org.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 1719 NW Edgar Street, McMinnville, OR 97128 MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
NAMCOA® – Naples Asset Management Company®, LLC