Do I Need an Intermediary for a 1031 Exchange?

In practice, yes, if you sell your property before you buy the replacement, which is called a delayed exchange. A qualified intermediary (QI) holds the sale proceeds and sends them to the closing of your new purchase, so you never receive the money. If you receive the cash, or can draw on it, the IRS treats the deal as a taxable sale. A QI can help postpone gain until a taxable sale of the replacement, but both properties must be held for business or investment and the exchange must meet the other 1031 rules. A property used solely as your personal residence does not qualify. Any sale money the QI returns to you unspent is taxed up to the amount of your gain. Mortgage debt relief not offset by replacement debt or additional cash can also make part of your gain taxable, even if all proceeds held by the QI are reinvested. Your attorney, accountant, real estate agent, or employee from the past two years cannot be your QI, and neither can a close relative.

Two setups work without a QI. One is a direct, same-day swap of deeds with the other owner. The other is a qualified escrow account or trust, which needs an escrow holder or trustee who is not you or any of the disqualified persons listed below, an agreement that bars you from the funds until the exchange ends, and works only if the buyer of your property agrees to acquire the replacement property and transfer it to you. For the other tax rules that apply to property owners, see tax benefits available to homeowners.

Why does a 1031 exchange need an intermediary?

In a delayed exchange there is a gap of up to 180 days between the sale and the purchase, or less if your tax return comes due first without an extension, and the money has to sit somewhere. The IRS counts money as yours once it is credited to your account, set aside for you, or available for you to draw on. That includes money your own agent receives for you. A QI that meets the regulations is not treated as your agent, so its holding the funds does not count as your receipt.

For that protection to apply, three things must be in place:

• A written exchange agreement with the QI, signed before the sale closes.
• Limits on your access. The agreement must say you cannot receive, pledge, borrow against, or otherwise use the funds until the exchange ends. The main exceptions: after day 45 if you identified no property, or once you have received all the property you identified.
• Assignment of the contracts. Your rights in the sale contract and the purchase contract are assigned to the QI, and the other parties are notified in writing on or before each closing.

How long you have to complete a 1031 exchange covers the 45-day and 180-day deadlines the QI's paperwork is built around.

Who cannot be your qualified intermediary?

The regulations call these people disqualified persons:

• You.
• Your agents in the 2 years before the sale: anyone who has worked for you as an employee, attorney, accountant, investment banker or broker, or real estate agent or broker in the 2 years ending on the date you transfer the property you are selling.
• Relatives: your spouse, brothers and sisters, parents and grandparents, and children and grandchildren.
• Companies you are tied to: a corporation or partnership in which you own more than 10 percent, and people or companies related in these same ways to one of your agents.

Two kinds of work do not make someone your agent. An attorney or firm whose only work for you was on 1031 exchanges can still serve. A bank, title insurance company, or escrow company that provided only routine financial, title, escrow, or trust services can also serve.

What does a QI do and what does it charge?

A QI typically:

1. Drafts the exchange agreement, the contract assignments, and the notices to the buyer and seller.
2. Receives the net sale proceeds at closing and holds them in an account.
3. Receives your written identification of replacement property by day 45.
4. Wires the funds to the purchase closing and returns any unused money after the exchange ends.
5. Keeps records of each transfer date and amount. Ask for a copy, since Form 8824 asks for those dates.

How to complete a 1031 exchange lays out these documents in order. The same company can also serve as the titleholder in a reverse exchange.

No federal rule sets or caps QI fees. Ask for a written fee schedule that lists every charge for your exchange and states who keeps the interest on your money while the QI holds it. That interest affects your taxes. If the QI pays you all the earnings, you report them as income. If the QI keeps some or all of them, the IRS treats the funds as a loan from you to the QI. You report any interest the QI pays you, but the rule that taxes interest you never received on a below-market loan does not apply to exchange funds of $2,000,000 or less held for 6 months or less.

How do you check a QI before you sign?

The federal tax rules set no license, bond, or insurance requirement for QIs. The IRS has warned that some intermediaries have gone bankrupt or failed to perform, and if the QI causes you to miss a deadline, your exchange does not qualify. A few states have filled the gap. Nevada requires a license from its Division of Financial Institutions for a QI handling the sale of Nevada property. Washington sets financial requirements without a license.

Ask for proof of the bond and insurance in writing; Nevada requires licensed QIs to provide it to clients. If your state has no rules, use these figures as the minimum you accept, and check with your state's financial regulator.

When should you hire one?

Before your sale closes, ideally when you sign the sale contract. The exchange agreement and the assignment of the sale contract must be in place before the proceeds are paid, so the closing agent can wire the money to the QI. Once the proceeds reach you, a QI cannot fix the exchange. If you plan to buy before you sell, the QI or a related company will need to set up a reverse 1031 exchange, and the rules for what a 1031 exchange covers still apply to both properties.