1031 Exchanges: Finding a Qualified Intermediary
Individuals who sell appreciated real estate must pay IRS capital gains tax. But under the IRS's 1031 Exchange rules, an exchange for new property purchased within a specified time period is not considered to be a sale, and no capital gain is recognized. The basis of the relinquished property becomes the basis of the replacement property, and tax is deferred until the replacement property is sold.
One of the basic requirements of a 1031 exchange is that the seller can’t touch the proceeds from the sale of the old property. This money must be held by an independent third party the IRS calls a “qualified intermediary.”
Who this person is and how he or she is compensated is an important issue. The IRS does not define what a qualified intermediary is. Instead, it tells you who can’t be an intermediary – your attorney, your CPA, your relatives, your business associates, anyone close to you. The intermediary must truly be an independent third party. No specific education, registration, or certification is required by the government. In fact, neither a clean criminal record nor U.S. citizenship is necessary. No one is going to protect you from a deceitful or incompetent intermediary, so doing your research is crucial.
Section 1031 is a form-driven code section, meaning that sellers must carefully fulfill all the requirements and meticulously document this in all the necessary paperwork. Any small infringement of the rules will get an exchange disallowed – with all the tax consequences. It is an intermediary's job to make sure that everything is done correctly.
Intermediaries are normally compensated in two ways: the fees they charge to handle the transaction and a portion of the interest earned while they hold the funds. Some intermediaries charge a single fee for the entire transaction, while others charge a separate fee for each piece: they may charge for the sale of the old property, another fee for the purchase of the new property, and a setup fee to handle the exchange account. The total fee can run anywhere from $600 - $1000. So make sure you understand all of the exchange costs.
Most intermediaries put exchange proceeds into a single account commingled with monies from other client’s exchanges. These commingled funds can be seized by any creditor of the intermediary, according to a recent court ruling. The court stipulated that only funds held in a separate account for specific transactions are safe from creditors.
The shared accounts draw a higher rate of interest and are often preferred by intermediaries, who keep at least part of the interest. These large accounts can be a temptation for abuse in the hands of a compulsive day trader, gambler, or thief so it’s best to make sure your money is in a separate account and that you are getting all the interest.
In summary, find and hire a qualified intermediary who has a record of ethical transactions, is open about charges, knowledgeable in tax law, and willing to keep your money in a separate account with interest earmarked for you.