Real estate investors have long taken advantage of Section 1031 exchanges to defer paying capital gains taxes in the process of buying and selling investment properties. By deferring taxes, you have more capital to buy your next investment, which makes 1031 exchanges a good wealth-building strategy.
Of course, the IRS doesn't let you avoid capital gains taxes automatically. You have to follow the rules, and they can get tricky. A Qualified Intermediary (QI) -- also known as an "Exchange Accommodator" or "Facilitator" -- can help.
These independent third parties act as fiduciaries during the exchange period, and they keep you in compliance with IRS rules when doing a 1031 exchange.
What is a 1031 exchange?
A 1031 exchange (or like-kind exchange) happens when you sell one property (the "relinquished property") and buy another property (the "replacement property") with the proceeds. You can defer paying capital gains and depreciation recapture taxes in the process.
To qualify as a 1031 exchange:
- The replacement property must be "like-kind."
- You must pay tax in the year you make the exchange on any "boot" -- the fair market value of cash, benefits, or other property that's not like-kind that you receive in the exchange.
- You must identify the replacement like-kind property within 45 days of selling the first property and acquire it within 180 days.
What is like-kind property?
"Like-kind" doesn't mean the properties have to be identical, or even similar. Instead, any real estate that you hold for productive use in a trade or business or for investment -- whether it's improved or unimproved -- is considered like-kind.
For example, you can exchange raw land for an office building, or a strip mall for an apartment complex. One caveat: Both properties must be in the U.S.
You report 1031 exchanges when you file your federal income tax return using Form 8824, Like-Kind Exchanges.
Investors aren't allowed to have access to sale proceeds during a 1031 exchange. The IRS is serious about this restriction. This is where the Qualified Intermediary comes into play. The QI acts on behalf of the exchanger as the facilitator of the 1031 exchange.
If you receive money from the sale directly (actual receipt) or receive control of the funds (constructive receipt), you forgo the chance to do a 1031 exchange. That means your gains become taxable.
That's where a Qualified Intermediary steps in. Acting as a fiduciary, the QI holds and protects the sale proceeds throughout the exchange while they:
- acquire the relinquished property from you,
- transfer the relinquished property to the buyer,
- acquire the replacement property from the seller, and
- transfer the replacement property to you.
Qualified Intermediaries also:
- Support you throughout the entire 1031 exchange process.
- Deposit funds in a restricted account and disburse them when needed.
- Coordinate with you, your attorney, and your tax advisor.
- Draft and help with the necessary tax and legal paperwork.
- Provide instructions and documents to the escrow or title company.
- Oversee the closings.
- Ensure the entire 1031 exchange complies with IRS guidelines.
Once the exchange is completed, you can access the funds from the transaction. But until then, it's the QI's responsibility to hold and protect the money.
The U.S. tax code doesn't specify who can act as your Qualified Intermediary in a 1031 exchange. But it does offer guidance on who can't.
Anyone who has acted as your "agent" within the two years before the exchange is disqualified. An agent is someone who agrees and is authorized to act on behalf of someone else.
You can't serve as your own QI, and neither can your:
- Family members
- Investment broker
- Tax advisor
- Real estate broker
A Qualified Intermediary must be an independent party who is truly neutral and who has no agency relationship with you. If you violate this rule, the IRS could prohibit the exchange, and the transaction could become taxable.
Learn the rules and timelines
A Qualified Intermediary is a key part of completing a successful 1031 exchange. Still, you're the one who's ultimately responsible for the exchange -- and any taxes that it might trigger. Be sure you understand the rules and timelines, and find a reputable QI who is experienced, insured, and bonded.