The Qualified Intermediary – a Crucial Player in your 1031 Exchange Transaction
1031 exchanges are used by real estate investors of all experience levels to defer capital gains taxes and build their investment portfolios. For any first-time Exchangor, starting and completing an exchange in compliance with all applicable rules and regulations can be an overwhelming task. Whether it’s understanding what needs to be done and when, preparing the proper paperwork, determining what questions need to be asked and who to ask them of, or looking out for potential audit risks, executing a 1031 exchange can seem daunting. By assisting taxpayers in addressing these potential challenges, a qualified intermediary, or “QI,” simplifies the process for Exchangors while providing the resources and framework needed to successfully complete their exchange.
The QI’s Role in Preventing Constructive Receipt
There are several essential guidelines for completing a successful exchange outlined in Chapter 26 of the Code of Federal Regulations, Sec. 1.1031(k)-1 (the “Treasury Regulations”). One of the most important requirements is that an exchanging taxpayer must avoid actual and constructive receipt of their funds when selling their relinquished property in an exchange. A taxpayer “receives” funds for tax purposes when their real estate sale closes and they receive sale proceeds directly, or if they have a right to the sales proceeds, even if they are not in actual possession of those funds, which is what creates “constructive receipt.” If the taxpayer’s agents take possession of the funds at closing instead of the taxpayer, the taxpayer will still be considered in constructive receipt of those funds.
The Treasury Regulations establish rules for creating a “safe harbor” exchange using a QI. A safe harbor exchange is one which, when set up in compliance with the Treasury Regulations, will protect a taxpayer from having constructive receipt of their proceeds. The taxpayer and the QI must enter into an agreement that limits the taxpayer’s access to their proceeds during the life of the exchange. These limitations are outlined in Sec. 1.1031(k)-1(g)(6) and referred to as the “(g)(6) rules”. Having a safe harbor exchange is a reliable way for a taxpayer to avoid constructive receipt (which would cause their exchange to fail). This removal of uncertainty is a huge benefit and one of the ways QIs provide great value to taxpayers using their services.
Note that the IRS rules provide that “disqualified parties” cannot act as a QI for a taxpayer – these are parties who have performed services for the taxpayer any time during the two-year period prior to the date the relinquished property sold, unless those services are limited to the client’s 1031 exchange. Therefore, a QI company provides a service that many taxpayers’ trusted contacts – including their attorney, employees, their investment banker or broker, a related party, or anyone with an agency relationship to the taxpayer – usually cannot.
Coordination and Guidance during the Exchange by the QI
Working with a QI does not only provide a safe harbor for the taxpayer to complete their 1031 exchange without constructively receiving funds – the QI also coordinates all required documentation, provides informational resources, guides the client through the 1031 process and points out potential issues or risk, and transfers property from and to the taxpayer by being assigned into the taxpayer’s sale and purchase contracts.
At the sale of the taxpayer’s relinquished property, the QI is assigned into the contract between the taxpayer and the buyer. The QI assumes all seller’s rights under the contract in order to receive payment for the property from buyer. The QI instructs the person preparing the transfer deed to directly deed the property from the taxpayer to the buyer; however, the QI directly receives the funds from the closing of the sale. All instructions and documentation necessary for this portion of the exchange, along with coordination of the 1031-related components of the sale, is prepared and conducted by the QI (with the assistance of any of taxpayer’s chosen tax advisors, attorneys or agents) at or prior to closing.
The QI also provides documentation and reminders throughout the life of the exchange. For example, the QI can send reminders to the taxpayer of its deadlines for both identification of properties, and for acquisition of those properties, as well as forms the taxpayer must complete to document the exchange throughout the exchange period. As questions arise, the QI is a resource to help guide the Exchangor through the ups and downs of the transaction.
When it comes time for the taxpayer to acquire their replacement property, the QI, like at the relinquished property sale, is assigned into the contract between the taxpayer and the seller, assuming buyer’s rights to acquire the property and buyer’s obligation to fund the acquisition. The QI is then able to fund the purchase, and instructs that the property be deeded directly from seller to the taxpayer. All documentation and coordination of this step of the exchange is handled by the QI, as well as documentation of the taxpayer’s completion of the exchange.
First American Exchange Company as Your QI
First American Exchange Company (“FAEC”) can provide all the tools and guidance described above as QI. With over 100,000 successful exchange transactions facilitated, and a staff of dedicated professionals with decades of combined experience conducting 1031 exchanges, FAEC has proven itself a leader in the industry. In addition, in using FAEC as QI, taxpayers can be comfortable knowing that their money is in safe hands.
First American Financial Corporation (NYSE: FAF) is a leading provider of title insurance and settlement services to the real estate and mortgage industries, which traces its heritage back to 1889. With revenues of over $7 billion annually, the company offers its products and services directly and through its agents and partners in all 50 states and abroad. FAEC operates as a direct subsidiary of First American Title Insurance Company (“FATIC”). FATIC is the largest subsidiary of FAF. This means that in most instances we can provide an indemnification letter protecting your transaction from loss of funds in the unlikely event of negligence, fraud, or dishonesty on the part of FAEC or its employees. In addition, as a subsidiary of a publicly traded company, FAEC is governed by the financial reporting and disclosure requirements set forth in the Sarbanes-Oxley Act.
Exchange funds are strictly deposited with FDIC insured institutions with investment grade ratings (or which are subsidiaries of investment grade institutions). FATIC’s Treasury team closely monitors the financial stability of these institutions. Exchange funds are also held in segregated bank deposit accounts designated with the taxpayer’s name and tax identification number. And, FAEC maintains a multimillion-dollar fidelity bond and a professional liability insurance policy from a leading independent insurance underwriter.
_______________________________________________________________________________
First American Exchange Company, LLC, a Qualified Intermediary, is not a financial or real estate broker, agent or salesperson, and is precluded from giving financial, real estate, tax or legal advice. Consult with your financial, real estate, tax or legal advisor about your specific circumstances. First American Exchange Company, LLC makes no express or implied warranty respecting the information presented and assumes no responsibility for errors or omissions. First American, the eagle logo, and First American Exchange Company are registered trademarks or trademarks of First American Financial Corporation and/or its affiliates.