The two primary responsibilities of the 1031 exchange accommodator is to provide:
- IRS compliant 1031 documentation;
- hold the exchange proceeds in a safe, liquid, non commingled escrow account.
Defalcations or when a Qualified Intermediary (QI) either absconds with the funds, declares bankruptcy or holds the funds in less than liquid securities will result in a failed exchange.
Qualified Escrow Account
Ask for the exchange proceeds to be held in a Qualified Escrow or Qualified Trust account. This is another level of protection in addition to holding the proceeds in a non-commingled account. The Qualified Escrow or Qualified Trust Account defines the procedures the Escrow Agent (the holding company or Bank), the QI and Taxpayer maintain and administer the exchange proceeds. Withdrawals are strictly monitored to comply with a written request to the Escrow Agent by the QI. The request must have an authorization signed by the Exchangor, stating the clearing account number, amount requested, and instructions to transfer the funds. The Escrow Agent will wire the exchange proceeds per instructions of the Taxpayer. The QI initiates the wire request by first submitting a disbursement authorization for Taxpayer to review, sign and return to the QI. QI submits to the bank. Bank calls the QI to confirm the wire instructions. Typically the funds can be wired the same day.
In summary, consider the following to secure your proceeds:
1. Engage a QI that is a member of the Federation of Exchange Accomodators (FEA) and has a Certified Exchange Specialist® on staff.
2. Be sure the Exchange Agreement clearly states the exchange proceeds are not considered assets of the QI.
3. Request a Qualified Escrow Account.
Disqualified Person
Don’t be lulled into a false sense of security. The reality is that anyone, except what the IRS designates as a disqualified person may perform the duties of a QI. A disqualified person for purposes of a deferred exchange is:
(1) The agent of the taxpayer at the time of the transaction. A person who has acted as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer a the time of the transaction. However, the following services will not be taken into account:
a. Services for the taxpayer with respect to exchanges of property intended to qualify for nonrecognition of gain or loss under Section 1031; and
b. Routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company.¹
(2) A person is a disqualified person if that person and the taxpayer bear a relationship described in either Section 267(b) or 707(b), determined by substituting in each section “10 percent” for “50 percent” each place it appears.²
(3) A person is a disqualified person if the person and a person who act as the taxpayer’s employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date of the transfer of the first of the relinquished properties bears a relationship described in either Section 267(b) or 707(b), again, determined by substituting in each section “10 percent” for “50 percent” each place it appears.³ Banks with affiliates that act as investment bankers are the exception.
Is a QI required for a 1031 exchange? Yes, with the exception of a pure exchange when each party exchanges for each other’s property. Even in this case, it is best to engage a QI as a contingency and as a confirmation the strict 1031 regulations are followed.
The Federation of Exchange Accommodators (FEA) is an association of small and large QIs that polices itself and subjects the fiduciary principal of each QI responsible for monitoring exchange proceeds to yearly criminal background checks. Furthermore, should the ownership of the QI change by more than 50 percent, the new principals are also required to have a criminal background check.
Security of the exchange proceeds starts with a FEA member whose Exchange Agreement includes verbiage similar to
“Exchange Account is to be used solely by Intermediary for its obligations under this Agreement and shall not be deemed a part of Intermediary’s general assets or subject to the claims of creditors of Intermediary.”
In the event the QI declares bankruptcy, the Exchange Agreement must make it abundantly clear that the exchange proceeds are the property of the taxpayer, not the QI.
¹ Reg § 1.1031(k)-1(k) (2).
² Reg § 1.1031(k)-1(k) (3).
³ Reg § 1.1031(k)-l (k) (4).
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