The role of the 1031 Exchange Accommodator otherwise known as a Qualified Intermediary, or QI, is to facilitate Internal Revenue Service (IRS) Code Section 1031 exchanges. The Regulations created four safe harbors for the purpose of determining whether or not the taxpayer has actual or constructive receipt of money or property while engaged in a 1031 exchange. Given the 1031 exchange utilizes one of the four safe harbors, the exchange will not be challenged by the IRS from the perspective of constructive receipt.
qualified intermediary
1031 Qualified Intermediary Role
An Internal Revenue Code section 1031 exchange allows for the deferment of capital gains taxes on the exchange of “like kind” property that is held for use in trade, business or investment. For example, if a rental property owner is moving and would like to sell his rental property in his current location, he can use the funds to buy new rental property in his new location, he could use a 1031 exchange to defer paying capital gains taxes on any appreciation in value the property experienced. If the property had depreciated and is selling for less than the purchase price, a 1031 exchange would defer the loss. If not all the funds are used to purchase the new property as in a partial 1031 exchange they will be taxed. “Like kind” property means that the properties exchanged are of the same nature or character. Foreign property is not considered “like kind” to property in the United States. Certain items, such as primary residence, inventory, partnership interests, indebtedness and stocks are explicitly ineligible for 1031 consideration.
Nevada, Oregon, Virginia and Washington 1031 Exchange State Laws
Eight states have legislated 1031 exchange laws that require the Qualified Intermediary (QI) accommodating the tax deferred exchange to follow or face criminal or civil penalties. The laws serve to protect taxpayer exchange proceeds, establish QI safeguards and procedures to alert the taxpayer of QI changes in ownership. Sanctioned by the Treasury Department and enforced by the Internal Revenue Service, the 1031 exchange allows taxpayers both domestic and foreign to defer federal and state capital gains and recaptured depreciation taxes when property held for the productive use in a business or investment is exchanged solely, for property held for productive use in a business or investment.
California, Colorado, Idaho and Maine 1031 Exchange State Laws
1031 exchange laws have been passed in eight states requiring Qualified Intermediaries to follow specific procedures to protect the exchange proceeds of their residents engaged in a 1031 tax deferred exchange. A 1031 exchange is a Section of the Treasury and IRS Regulations that provides taxpayers a tax deferral on the federal capital gains and recaptured depreciation tax when real or personal property held for investment or in a business is sold and replaced with like-kind property. A Qualified Intermediary (QI) is the third party who accommodates the exchange, providing documentation in accordance with the Treasury and IRS requirements and holding the exchange proceeds. States also recognize the federal statute allowing the taxpayer to defer state capital gains taxes if applicable.
1031 Exchange Qualified Intermediary
The 1031 exchange Qualified Intermediary (QI) was one of four safe harbors the 1031 Regulations created in 1991 for use in a 1031 exchange to fulfill the requirement that the taxpayer is not in actual or constructive receipt of exchange funds or property as part of a 1031 exchange. If it is determined that the taxpayer has or had access to the funds during the exchange, the 1031 exchange may very well be nullified and taxes deferred due. A QI under Safe Harbor Number 3 is not recognized as the taxpayer’s agent for purposes of the 1031 exchange.
1031 Exchange Safe Harbor: Qualified Escrow and Qualified Intermediary
In 1991, the Department of Treasury published regulations creating four safe harbors defining conditions and constraints to determine whether the taxpayer is in actual or constructive receipt of money or other property for the intent of Internal Revenue Code (IRC) § 1031. IRC Section 1031 states “no gain or loss is recognized when property held for productive use in a trade, business or investment is exchanged for property held for productive use in a trade, business or investment.” The outcome of the code allows taxpayers to defer the capital gain and recaptured depreciation taxes for real and personal property held for use in a business or investment.
Constructive Receipt
The purpose of the safe harbors is to prevent the taxpayer from the receipt or control over transactional proceeds. For example, in a property closing, a settlement agent may mistakenly complete a 1031 exchange without a Qualified Intermediary (QI) by transferring the proceeds from one escrow to another, believing that is acceptable when in fact, the taxpayer as principal is deemed to have received the transactional proceeds given the settlement agent is the taxpayer’s agent, violating the g(6) constructive receipt limitations and invalidating the exchange. Equally important , there must be a series of agreements supporting the taxpayer’s intent to initiate a 1031 exchange in accordance with IRC regulations, linking the interdependent transactions of the property disposition and acquisition.
Safe Harbors
Given the exchanging taxpayer cannot have access to the proceeds between the time the relinquished and replacement property are sold and acquired, the regulations provide protection for the taxpayer, preventing possession of the cash. Known as Safe Harbors, the most common are a QI and Qualified Escrow Holder. The independent, arms-length QI is unrelated, a non-employee and under Safe Harbor No. 3, not considered an agent of the taxpayer for purposes of the 1031 exchange.
Taxpayer assignments enable the QI to sell and acquire the old and new property with notice of assignments and an exchange agreement drafted to support the 1031 requirements. The QI will also typically hold the exchange proceeds preventing taxpayer access until the funds are needed for the replacement property. The funds are often held in qualified escrow accounts requiring dual signatures or accounts requiring personal identification numbers for disbursement.
Care should be exercised when selecting a QI, given the industry is not regulated though the Bureau of Consumer Financial Protection is tasked with developing regulations.