Law Offices of Ronald D. Jackson

Real Estate

How to Choose a Qualified Intermediary in a 1031 Exchange

What 1030 exchangers need to know about the man-in-the-middle

Disclaimer: This is not legal advice.

If you're considering a 1031 exchange, you're probably fully focused on identifying economically acceptable replacement property within the time allowed by the tax rules, and closing the acquisition of the replacement property within the time allowed. However, you may not be aware of a third issue that is key to your successful completion of a 1031 exchange, and thus much deserving of your undivided attention: choosing a reliable "qualified intermediary" to facilitate the exchange.

Don't be embarrassed if you, like many other investors, don't know what a "qualified intermediary" is, or how to choose one wisely. After reading this short article, you'll understand all you generally need to know about "qualified intermediaries", and how to select one wisely.

What is a "qualified intermediary"?

In a 1031 exchange, an investor who sells investment property defers capital-gains taxes if he or she invests the proceeds in "like kind" property within 180 days. However, to qualify for the favorable tax treatment, the investor can't touch the money from the sale. Instead, the investor must place the money into a 1031 exchange account until it's used to buy a new property. This is where a "qualified intermediary" or man-in-the-middle comes in. The investor hires an intermediary to handle the money in the 1031 exchange account until the investor is ready to close on a new property, which consummates the 1031 exchange. While many large commercial banks and title insurance companies offer intermediary services through affliated companies, the intermediariary services industry is largely unregulated.

Based on the above description of the "qualified intermediary's" role, you can appreciate why it is important to choose an intermediary carefully. To make the issue even more urgent, consider the following scenarios:

What happens if your "qualified intermediary" files for bankruptcy protection before you close on the replacement property?

What happens if the intermediary absconds with the money?

What happens if the intermediary misappropriates your money for his or her own project?

No one likes to think the worst of other people, but any of the above scenarios is possible. If your intermediary does any of those things, you're not likely to complete the exchange within the allotted timeframe. It will mean that you will lose the advantage of a 1031 exchange, and will owe the IRS a lot of money!

Take these steps to choose an intermediary wisely?

Understand the current nature of the qualified intermediary industry. Recognize that the "qualified intermediary" services industry is largely unregulated. It is hard to believe that an industry charged with holding and investing billions of dollars of annual exchange funds is largely without governmental oversight, but this is true. Indeed, it is an industry with few barriers to entry, and many players. Generally, intermediaries do not have to be licensed, and are not required to comply with any minimum capitalization, insurance, or bonding requirements. Only the contract between the "qualified intermediary" and the investor defines what the intermediary can do with the money entrusted to it. This means that if the contract doesn't prohibit it, an intermediary is free to do pretty much whatever it pleases with an investor's money. Indeed, nothing in the tax code prohibits a "qualified intermediary" from spending an investor's money on his or her pet project. Of course, if that happens, the investor may have a lawsuit for breach of contract (assuming the contract prohibits such acts), but the intermediary may not have broken the law.

Use the diversity in the industry to protect yourself. The intermediary services industry is diverse with many independent players as well as entities affiliated with large financial institutions such as national banks and title insurance companies. One strategy might be to hire an intermediary that is affiliated with a regulated entity. Although the intermediary industry is largely unregulated, if you have a dispute with your intermediary, you may be in a better position if the intermediary is affiliated with a regulated entity such as a bank. However, don't make assumptions about any intermediary! The fact that an intermediary is affiliated with a regulated entity does not mean that you won't have problems. An independent intermediary can provide as good or better service as one that's affiliated with a large financial institution. Also, just because someone recommends an intermediary to you does not mean that it is the best choice for you.So shop around, and take advantage of the industry's diversity.

Ask questions before you hire an intermediary. The best thing you can do is ask lots of questions and wait for complete answers. Ask about the intermediaries' claim history, its financial condition, expertise, years in the business, volume of business, how it handles investors' money, and other things you want to know. Seek professional help if you don't know what to ask or feel uncomfortable with the answers.