A 1031 exchange represents a Section of the Internal Revenue Code that allows a taxpayer, whether an individual, husband and wife, trust, limited liability company or corporation, to defer federal and state capital gain and recapture depreciation taxes when selling real or personal property held in the productive use of a business or for investment. There are many rules to follow and it is the responsibility of the Qualified Intermediary (QI) to enforce the 1031 rules by effectively accommodating the 1031 exchange and holding the net equity in a manner to preserve principal and liquidity. The QI must be an independent, third party entity, separate from the taxpayer, who is not considered an employee, agent or related to the taxpayer.
Disqualified Person
What about the taxpayer’s CPA, Realtor, Attorney or-Financial Advisor-can they act as the taxpayer’s QI or escrow agent? Enter the disqualified person who is defined as a related person or agent of the taxpayer. A partial list of disqualified persons includes:
- Family members including, spouse, ascending and descending descendants
- An individual who owns ten percent in value of stock owned directly or indirectly by the taxpayer
- Grantor and fiduciary of the same trust
- Two corporations that are a part of the same control group
- A corporation and a partnership if the same persons own more than 10 percent in value of the outstanding stock of the corporation and more than 10 percent of capital interest or profits interest in the partnership
An agent of the taxpayer is considered a disqualified person if at the time of the transaction, the agent 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 relinquished property transfer. The spouse of an attorney who has provided legal services to the taxpayer is considered a disqualified person. The attorney’s or CPA’s firm is considered a disqualified person if the taxpayer has engaged an attorney or CPA in the firm to provide legal or financial services.
National Carbide v. Commissioner (1949) provides four factors defining “agent” status as to whether the designated party (1) operates in the name and for the account of the principal; (2) binds the principal by its actions; (3) transmits money received to the principal and (4) whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal as supported by Private Letter Rulings 200630005, 200803003 and 200803014.
The cautious taxpayer will not use the closing attorney as the QI or have the closing attorney park the exchange proceeds in the attorney’s trust account rather the exchange funds should be wired directly to the escrow created to hold the exchange funds by an independent QI or trustee. There are exceptions to the disqualified person rule.
Exceptions
If the attorney has provided only real estate closing services, then they are not considered a disqualified person. Title and escrow companies can provide QI services. Those who have provided routine financial escrow, or trust services for the taxpayer by a financial institution are eligible to act at a QI or escrow agent for the taxpayer. Consequently, banks can provide QI services and hold exchange proceeds for the benefit of the exchanging taxpayer. A bank acting as the taxpayer’s trustee of a qualified trust does not constitute a disqualified person.
Engaging your attorney to provide QI or escrow account services jeopardizes the (g)(6) constructive receipt limitations of the code, potentially enabling the taxpayer to access the exchange funds in the 1031 exchange. Discovery by the IRS that the taxpayer has access to the exchange proceeds will invalidate the 1031 exchange.
Understanding the disqualified person rules is important for every taxpayer initiating a 1031 exchange. To learn what questions to ask a QI when selecting a QI, click here to learn what experienced exchangors ask.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
