What are the Requirements to be a 1031 Exchange Qualified Intermediary?

Who can be a QI, who can’t, and what your QI should provide in order for your exchange to be successful.

One of the best things about Internal Revenue Code Section 1031 is that anyone who owns business or investment property can take advantage of it. Whether you own a single rental property, run a small business, are an executive at a corporation, or represent a DST sponsor, you can defer taxes through a 1031 exchange.

However, because Section 1031 has been around so long (more than 100 years) and so many different types of businesses take advantage of it, a lot of the information that’s out there can be quite technical and takes certain knowledge for granted. For property owners who’ve never performed an exchange before or who haven’t in many years, it’s important to learn some of the terminology and get explanations that aren’t in legalese.

When researching 1031, you’ll see plenty of websites and ads for the many companies hoping to be your Qualified Intermediary (QI). But what does a QI actually do? How does one become a QI? And how can you be sure your QI has the capabilities you need? Understanding the rules that are actually in place (and the rules that aren’t in place) can give you a better understanding of what you need for your exchange.

What is a 1031 Qualified Intermediary and why do you need one?

When you sell a property, the proceeds will be subject to capital gains taxes. If your plan is to purchase another property, paying these taxes would reduce the capital you have to invest in your subsequent property, essentially forcing you to downgrade or add cash to make up for the money lost to taxes.

A 1031 exchange solves this issue by allowing investors to defer capital gains taxes if they use the sales proceeds to purchase another business or investment property. Because they’re essentially trading one property for another, the taxes are deferred until a property is sold through a taxable sale. This gives property owners greater incentive to pursue new property deals and encourages economic activity while allowing taxpayers to build more wealth by upgrading to more valuable properties.

1031 works because the IRS understands that you aren’t selling your property for cash, but are “exchanging” it for a new property. It’s possible for two parties to exchange properties, one for the other, though this is uncommon; most likely, you’ll sell your relinquished property to one party and acquire your replacement property from another.

Similarly, while it’s possible to sell your relinquished property and acquire your replacement property simultaneously so that the relinquished property sales proceeds go directly to the seller of the replacement property, this isn’t usually realistic. In most cases, one transaction will happen first. If the relinquished property is sold first, that’s known as a forward (or deferred) exchange. If the replacement property is acquired first, that’s known as a reverse exchange.

Because it’s unrealistic to expect exchangers to buy and sell on the same date, we have the 1031 exchange timeline, which provides specific deadlines. In a common forward exchange, the exchanger has 180 days from the date of sale of the relinquished property to acquire the replacement property. But what happens to the cash received during those 180 days?

The law does not allow the exchanger to take actual or constructive receipt of funds while the exchange is in progress. Instead, you must engage the services of a Qualified Intermediary that will oversee the account holding the sales proceeds until they are deployed to purchase the replacement property. This way, you won’t take receipt until after the exchange is over. Because the QI is overseeing your capital, this is an important role that should be filled by someone you trust. However, there are rules about who can and cannot be your QI.

Who can’t act as a Qualified Intermediary

§1.1031(k) outlines “disqualified persons” who can’t act as QI for your 1031 exchange because they are considered your “agent,” including “a person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties.”

In the same way, personal relationships can prevent an individual from being a QI. You can’t be your own QI, even if the taxpayer in the exchange isn’t actually you, but a partnership or LLC of which you are a member. Blood relatives and spouses are disqualified, though in-laws can potentially qualify. Coworkers are generally not permitted, and anyone who co-owns any business with you is not allowed because of their personal and financial connection to you.

Who can be a QI for my 1031 exchange?

Beyond disqualifications stemming from conflicts of interest, there is little preventing any individual or company from acting as QI for a 1031 exchange. First-time exchangers may think anyone advertising themselves as a QI has passed some sort of certification exam or must follow strict regulation, but this isn’t the case.

As JTC’s Justin Amos noted, the QI industry is largely unregulated, and there is no formal process for becoming a QI. This allows for a great deal of flexibility, but also means there is a lot of room for those who aren’t trustworthy or capable to insert themselves into the business.

The dangers of selecting the wrong Qualified Intermediary

Because there are so many choices out there, exchangers often choose their QI based on who offers the lowest prices or a QI that is near where they live, but this can be a mistake. Just because a QI is close doesn’t mean they’re experienced, and the security of your investment isn’t a place where you want to cut corners. Here are just a few of the things that could happen if you pick the wrong QI:

1. Your QI could steal your money. Like most industries, the QI landscape is open to the possibility of fraud. If you end up with a QI that violates your agreement or absconds with your money, getting it back could be difficult and would almost certainly take long enough to prevent you from finishing your exchange.
2. Your QI could mismanage your funds. Your QI should hold your exchange funds in a qualified escrow or qualified trust account. If your QI commingles your funds with other exchangers’ or their own operating expenses and doesn’t keep proper records, your funds may not be available when you need them. And if your QI uses your funds for a risky venture and loses them, you could have to take legal action.
3. The QI could go bankrupt while your funds are in their master account. The QI receives your sales proceeds in their master account before transferring them to a dedicated account. But what if the QI is slow in making this transfer, and goes bankrupt while your funds are mixed with others? The bankruptcy process could take long enough for your exchange to fail.
4. The QI could fall victim to wire fraud or cyber crime. In many cases, the QI has the sole ability to transfer funds to the seller of the replacement property. If they make a mistake (or fall victim to fraud) and send the funds to the wrong account, those funds may be unrecoverable.
5. The QI could be unable to make the transaction when you need them to. In some cases, it’s possible for a bank to be your QI and escrow agent. But if there is an issue at the bank such as a service outage, it will likely also extend to the QI or escrow arms of this institution, leaving you with no one to help you complete your exchange.

With so few requirements for QIs, exchangers have to perform their own due diligence. Given that your financial future is at stake, it’s worth understanding what separates the best QIs from the rest.

What legitimate Qualified Intermediaries provide for their clients

We’ve told you what can happen with an untrustworthy or incompetent QI, so how do you select the right one? Even though these elements aren’t all required by the IRS, they are things you should look for in order to determine if your QI has the proper procedures and controls in place.

First of all, you’re going to need a QI agreement, and your QI should be willing to work with your legal counsel to ensure it contains everything necessary for the exchange. You also need to make sure your QI understands the particulars of your exchange, something that can only come with experience. This may be your first exchange, but it shouldn’t be your QI’s. Even experienced QIs sometimes can’t handle complex transactions like reverse exchanges, improvement exchanges, or DSTs. JTC, on the other hand, has a team with specific expertise in all three.

The QI should deposit the exchange funds in a qualified escrow or qualified trust account and provide FDIC insurance protection. Having an independent escrow agent like JTC means you can move your funds quickly when necessary. Additional security features like cyber insurance, a fidelity bond, and SOC 1 Type 2 audits are additional components of 1031 best practices.

The best QIs also provide full transparency, which JTC does in the form of our Exchange Manager portal that offers visibility into account status 24/7 from anywhere in the world. That way, you’ll always know where your funds are and that they haven’t been moved without your consent.

When it comes time to transfer funds, you want to be sure that you and the QI are on the same page. That’s why JTC requires dual authorization for all transfers, meaning both JTC and the exchanger must approve the transfer before it is made. You can’t be too careful, and putting these checks in place means you can rest easy knowing your money won’t be sent without your approval.

While these are all important elements of a QI, the most important is the relationship you have with them. You don’t want a QI you can’t get on the phone, or one that treats your exchange as less important than those of its larger clients. JTC offers a dedicated point of contact so you’ll always know who to call when there’s an issue. We provide first-time exchangers with the same institutional-grade solutions we offer to large corporations because no matter how big your exchange, we know that to you, it means everything.

To learn more about JTC’s Qualified Intermediary services, click the link below.