How to Choose a Qualified Intermediary for Your 1031 Exchange

Choose a qualified intermediary the way you would choose a place to park several hundred thousand dollars for six months, because that is what you are doing. The most important questions are about how your money is held, who can move it, and what insurance stands behind the company. Fees and convenience come after that.

This post is a vetting checklist you can work through on a phone call. It does not name or rank companies, because the right questions matter more than a brand.

What a qualified intermediary does

In a 1031 exchange, you cannot receive the proceeds from your sale or have the right to get them. If you do, the sale is taxable, even if you buy another property right away. A qualified intermediary (QI), sometimes called an exchange accommodator or facilitator, solves that problem by standing in the middle:

1. Before your sale closes, you sign an exchange agreement with the QI and assign your rights in the sale contract to them.
2. At closing, the proceeds go from the closing agent straight to the QI.
3. You deliver your written identification of replacement property to the QI by day 45.
4. When you buy, the QI wires the funds to the closing of the replacement property, which has to happen by day 180, or by your tax return due date for the year of the sale if that comes first, so file an extension for a late-year sale.

The QI has to be in place before the sale closes. There is no way to fix this after the fact, so hire one when you list the property.

One detail surprises people. The exchange agreement has to limit your access to the money, and those limits are what make the exchange valid. In general you cannot get funds back before day 45. If you have identified property, you generally cannot get funds back until you have bought everything you identified or day 180 has passed. A QI that offers to release money whenever you ask is putting your exchange at risk.

Why vetting matters

QIs are not federally licensed. There is no federal exam, no federal capital requirement and no federal audit. A handful of states regulate exchange companies with rules on bonding, insurance or how funds are held. Nevada, California and Washington are among them, and the details differ in each. In most states, anyone can open an exchange company.

QIs have failed before. During the 2008 financial crisis, several exchange companies collapsed, and in other cases owners simply took client money. Investors lost their funds, or had them frozen in bankruptcy for years, and lost the tax deferral as well because the deadlines kept running.

You can estimate what you have riding on the exchange with the 1031 exchange calculator. For most small investors it is the largest sum they will ever hand to a company they found a few weeks earlier.

Who cannot be your QI

The regulations bar "disqualified persons" from serving as your intermediary. In general that means:

• Anyone who has acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two years before your sale closes.
• Close family members, and entities in which you or those people hold more than a 10% interest.

So your own agent, your own attorney, your CPA and your employees are out if they did that work for you in the prior two years. There are narrow exceptions. Someone whose only work for you was on prior 1031 exchanges is not disqualified by that work, and routine title, escrow, trust and financial services by a bank or title company do not count against them.

This rule is why you usually need an independent exchange company. It also means you should be careful with a friend's law firm that offers to "just hold the money" for you.

The vetting checklist

Ask every QI you interview the same questions and write down the answers.

How your funds are held

This is the most important item on the list. There are roughly three ways a QI holds exchange money.

• Commingled. Your proceeds sit in one pooled account with other clients' money, or even with the company's operating cash. This is the weakest setup. If the company fails, you are probably an unsecured creditor standing in line.
• Segregated. Your funds are in a separate account set up for your exchange under your name or tax ID. This is better, because the money is easier to trace and harder to misuse quietly.
• Qualified escrow or qualified trust account. These are arrangements recognized in the 1031 regulations. A third party escrow holder or trustee, usually a bank or trust company, holds the money under a written agreement, and funds move only according to that agreement. Many QIs set these up so that a withdrawal needs your written approval as well as theirs.

Ask for a qualified escrow or qualified trust account with dual authorization. Some QIs include it, some charge a few hundred dollars more, and some will not offer it. If the answer is no, consider that a reason to keep looking.

Also ask which bank holds the deposits and how the account is titled. FDIC insurance has a standard limit of $250,000 per depositor per bank, and exchange balances often go well past that. Some QIs spread large balances across several banks. Ask how they handle it, and do not assume your whole balance is insured.

Fidelity bond and E&O coverage

These two policies cover different problems.

• A fidelity bond covers theft or dishonesty by the QI's own people.
• Errors and omissions (E&O) insurance covers mistakes, such as a missed deadline or a badly drafted document.

Ask for the dollar limits and for copies of the certificates. Then ask whether each limit is per occurrence or an aggregate for the whole company. A $1 million aggregate bond sounds large until you remember the company may be holding many times that amount across all of its clients. Insurance helps, but it is a backstop. Segregated or escrowed funds with dual control do more to protect you, because they make a loss less likely in the first place.

Experience and reachability

You will need answers fast around day 40 and again near closing. Ask who your contact is, how quickly they turn around documents, and whether they have handled your situation before. That matters most for anything beyond a standard delayed exchange, such as a reverse exchange, an improvement exchange, or a sale by a partnership. Membership in an industry trade group or a professional exchange designation shows some commitment to the field, but it is not a license and it does not guarantee your money is safe.

Be wary of a QI who gives you tax advice about your own return. A good one explains the exchange rules and tells you to confirm your numbers with your CPA.

Fees, and who keeps the interest

For a standard delayed exchange with one sale and one purchase, QI fees are commonly quoted somewhere around $600 to $1,500. Expect extra charges for additional properties, and expect several thousand dollars more for a reverse or improvement exchange. These are typical quotes, not a published price list, so get yours in writing.

The flat fee is only part of the cost. Your money earns interest while the QI holds it, and the exchange agreement decides who keeps that interest.

Example. You are comparing two QIs for an exchange that will hold $400,000 for about three months. Assume, for this example only, that the account earns 3% a year.

• Interest earned: $400,000 times 3% = $12,000 a year, and one quarter of that is $3,000.
• QI A charges $1,200 and passes all the interest to you. You pay $1,200 and receive $3,000, so you end up $1,800 ahead.
• QI B charges $800 and keeps all the interest. You pay $800 and receive nothing, so you end up $800 behind.

The QI with the lower sticker price leaves you $2,600 worse off in this example ($1,800 plus $800). Any interest you receive is taxable interest income, but you would still prefer to have it.

Do not pick on price alone in either direction. A $400 difference in fees is small next to a $400,000 balance. Decide on fund security first, and only then compare cost.

What happens if a QI fails

If your QI goes bankrupt or the money disappears, three things tend to happen together.

1. Your funds are frozen or gone. With commingled funds, you are likely an unsecured creditor in a bankruptcy case that can take years.
2. The 45 and 180 day deadlines keep running. Without the money you usually cannot close on the replacement, and the exchange fails.
3. The failed exchange becomes a taxable sale. You can owe capital gains tax and depreciation recapture on proceeds you never received.

The IRS has published limited relief for taxpayers whose QI ends up in bankruptcy or receivership. In general it lets you report the gain as you actually recover money, so you are not taxed on all of it in the year of sale. It does not rescue the exchange, and it does not get your money back. If this ever happens to you, call a tax attorney right away.

The protections in the checklist above are what reduce this risk. Money in a qualified escrow or trust account that needs your signature to move is far harder to lose than money sitting in a company's pooled account.

When to hire, and where to look

Start interviewing when you decide to sell. A workable timeline:

• At listing: interview two or three QIs using the checklist above. The qualified intermediary directory is a starting point, and your CPA or closing attorney will usually know a few as well.
• At contract: sign the exchange agreement and give the QI's contact details to your closing agent.
• At closing: confirm the settlement statement shows proceeds going to the QI, and get written confirmation of the deposit.
• By day 45: deliver your signed identification and keep proof of delivery.

While you are planning, estimate your taxes in the investor tax tools. If you have taken years of depreciation, or did a cost segregation study, more of your gain is taxed at higher rates and a failed exchange costs more.

Common mistakes

• Calling a QI the week of closing. Rushed paperwork is how errors happen, and it leaves no time to compare companies.
• Using your own attorney or agent. If they worked for you in the last two years, they are disqualified and the exchange is invalid.
• Never asking how the money is held. Many investors only ask about the fee.
• Accepting "we are bonded and insured" without numbers. Ask for the limits, whether they are per loss or aggregate, and the certificates.
• Ignoring the interest. As the example shows, it can be worth more than the fee.
• Asking for money back early. A QI that agrees to release funds outside the permitted windows can blow up the exchange.
• Assuming state regulation protects you. Most states have none, and where rules exist they vary by state.

Bottom line

A qualified intermediary is a legal requirement for a delayed exchange and also the biggest single point of risk in it. Pick one early, insist on segregated funds in a qualified escrow or trust account with your signature required, get the bond and E&O limits in writing, and understand the full cost including interest. Then read the 1031 exchange basics so you know what the QI will need from you, and see how the exchange fits your broader tax strategy.

This article is general information, not tax or legal advice. Confirm your situation with a CPA.