How to Choose a Qualified Intermediary for your 1031 Exchange

There is an old adage that states “Just because you can do something-doesn’t mean you should.” This sage advice certainly applies to choosing a qualified intermediary to facilitate a 1031 like-kind exchange. The use of a qualified intermediary is essential to completing a successful 1031 exchange because, while the process of completing an exchange is straightforward, the rules are complicated and loaded with potential pitfalls for the exchanger if the exchange is not properly prepared.

To simplify the discussion and underscore the potential challenges of selecting a qualified intermediary, let’s identify parties who cannot act as a qualified intermediary. This list is relatively short and essentially disqualifies those who have acted in some advisory capacity for your company during the two years prior to a potential exchange:

1. Section 1031 of the Tax Code, with certain limited exceptions, prohibits exchanges where the taxpayer intends to acquire replacement property from a related party. Related Party is defined in I.R.C. § 267(b) or 707(b)(1) and generally covers exchanges between family members as well as exchanges between other entities where there is a high commonality of ownership. Related Parties – Including certain family members and business entities with shared/common ownership.
2. Agents – Including individuals that have provided services to the exchanging taxpayer as an employee, attorney, accountant, investment banker or broker within the two year period ending on the date of the transfer of the first of the relinquished properties.

Aside from the above, virtually anyone can legally act in the capacity of a qualified intermediary, and therein lies the potential for disaster.

I spoke about 1031 exchanges recently at a conference where one of the attendees, an equipment dealer who had advised a customer on their like-kind exchange, stated his belief that the only requirement for a qualified intermediary was that they be a third party who could hold the money from the sale of the relinquished equipment until the seller requires the money for the purchase of replacement property.

While it's true that any third party can legally provide the service outlined above, they'll likely fall short of providing a properly-structured 1031 exchange that satisfies the Internal Revenue Service's safe harbor guidelines. I inquired further:

• Did the selling party execute an Agreement between the Exchanger and the Qualified Intermediary, establishing the Exchanger’s intent to complete a Like-Kind Exchange and detailing each party’s roles and responsibilities. The Exchange Agreement must detail the exchange in accordance with the deferred exchange regulations. Exchange Agreement outlining the safe harbor compliance rules? Without specific restrictions on the sales proceeds contained in this agreement, the exchanger still has constructive receipt of funds from the sale.
• Did the third party create a separate bank account for the specific benefit of the seller/exchanger during the exchange period?
• Did the seller notify the buyer that they had assigned their interests and rights in the sold equipment to the qualified intermediary?
• Did your customer notify the seller that he had assigned his interests and rights in the new equipment to the qualified intermediary?
• Did your customer send a Replacement Property Section 1031(a)(3) and Section 1.1031(k)-1(c) provides that a written unambiguous description of the intended replacement property or properties, signed by the taxpayer must be sent to the qualified intermediary or other person who is a party to the exchange and who is not a disqualified person. Identification Notice to the qualified intermediary before the expiration of the identification period, identifying the equipment the buyer planned on purchasing by one of the two approved methods?
• Did you (the equipment store) notify the customer that he had 45 days to identify potential replacement equipment and up to 180 days from the sale of the used equipment to purchase the new replacement equipment?
• Did you provide all of the documentation and signatures required by the Treasury to ensure that the seller indeed satisfied the IRC safe harbor compliance rules and regulations?

When the color returned to his face and the nausea had passed, the equipment dealer uttered the far too common response of someone who had purported to serve as a qualified intermediary but was not one.  “All we did was hold the money and then forward it to the seller when it came time to buy.”

Like-kind exchanges offer sellers of used equipment a tremendous opportunity to reinvest in funds that would otherwise be lost to taxes, but in order to enjoy this benefit exchangers must follow a document and deadline driven process. When engaging a qualified intermediary, be certain that they understand the necessary documents, steps, and safe harbors that are inherent in Section 1031. Doing so will result in a properly-structured and secure exchange.

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