How to Choose a Qualified Intermediary for a 1031 Exchange

What does a qualified intermediary actually do?

In a delayed exchange, you sell one property and buy another within 180 days. If the sale proceeds land in your account, even for an afternoon, you've received them and the exchange fails. The QI solves that problem. It stands between you and the money for the whole exchange period.

Under Reg. §1.1031(k)-1(g)(4), a qualified intermediary is a person who isn't you or a disqualified person, who enters into a written exchange agreement with you, and who, under that agreement, acquires the relinquished property from you, transfers it to the buyer, acquires the replacement property and transfers it to you. In practice the QI rarely takes title. The regulation treats the intermediary as acquiring and transferring property if your rights in the sale and purchase contracts are assigned to it, and all parties to those contracts are notified in writing of the assignment on or before the closing date. Then the deeds go directly from you to your buyer and from your seller to you.

Here's what a QI does in a typical delayed exchange:

1. Prepares the exchange agreement, the assignment of your sale contract, and the written notice to your buyer.
2. Sends wiring instructions to the escrow or title company handling your sale, so the net proceeds go straight to the QI.
3. Holds the funds under the restrictions the regulations require.
4. Receives your written identification of replacement property by day 45.
5. Prepares the assignment of your purchase contract and notice to your seller, and wires funds to the replacement escrow.
6. Releases any leftover funds only when the regulations allow, and sends the paperwork your CPA needs for Form 8824.

Your QI doesn't give tax advice, doesn't tell you whether a property qualifies, and usually doesn't review your closing statements for boot. That's your CPA's or tax attorney's job. Some QIs are knowledgeable and generous with guidance, which is valuable, but the exchange agreement almost always says the QI isn't responsible for your tax result.

What restrictions apply to the money?

The safe harbor only works if the exchange agreement limits your right to the funds. Under Reg. §1.1031(k)-1(g)(6), you can't have the right to receive, pledge, borrow or otherwise get the benefits of the money before the exchange period ends, except in specific cases:

• If you identify no replacement property by the end of the 45-day identification period, the funds can be released after that period.
• If you identify property and acquire everything you identified, the funds can be released after that.
• If a material and substantial contingency outside your control occurs after the identification period, related to the deferred exchange and written into the agreement, the funds can be released.
• Otherwise, the funds are released at the end of the 180-day exchange period.

That's why you can't change your mind on day 60 and ask for your money back if you've identified a property you haven't bought. The QI isn't being difficult; it's following rules that protect your exchange.

Who can't be my qualified intermediary?

The regulations bar "disqualified persons," and the definition is broader than most people expect.

Your agents. Reg. §1.1031(k)-1(k)(2) treats as disqualified anyone who acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date you transfer the first relinquished property. If your CPA prepared last year's return, or the attorney who drafted a lease for you 18 months ago wants to serve, neither can be your QI.

Exceptions. Two kinds of service don't count. Services performed solely for 1031 exchanges don't make someone your agent, which is why a QI that handled your last exchange can handle this one. And routine financial, title insurance, escrow or trust services provided by a financial institution, title insurance company or escrow company don't count. Your bank isn't disqualified because you have a checking account there, and a title company isn't disqualified because it insured your last purchase.

Related parties. People and entities related to you under §267(b) or §707(b) are disqualified, with a twist: the regulations substitute 10% for the usual 50% ownership threshold. A company your brother owns, or an entity in which you hold more than a 10% interest, is out.

People related to your agents. A person related to one of your agents, under the same 10% test, is also disqualified. If your real estate broker's firm owns more than 10% of an exchange company, that exchange company is likely disqualified. There's a narrow exception added in 2001: a bank or bank affiliate isn't disqualified only because it's in the same controlled group as a firm that provided investment banking or brokerage services to you in the two-year window.

I've seen owners propose using a friend's company, a family member, or the escrow company's in-house "exchange department" that turns out to be owned by the listing broker. The fix is easy if you catch it before closing and impossible after. Ask any prospective QI to confirm in writing that it isn't related to you, your broker, your attorney or your CPA.

Who regulates qualified intermediaries?

Less than you'd think. There's no federal licensing requirement for QIs, no federal capital requirement, and no federal agency that examines them. The IRS defines what a QI must do for your exchange to qualify; it doesn't supervise whether a QI is solvent or honest. Most QIs are not banks, so there's no banking regulator looking at them either, unless the QI is a bank subsidiary.

A handful of states have passed laws after the failures I describe below. As of my research for this guide, these are the states with QI-specific statutes or regulatory regimes:

A few observations about these laws. First, most states have nothing. Second, only Nevada and Maine require a license, and Idaho's regime runs through its escrow statute. Third, a $1 million bond sounds substantial until you realize it may cover every client the QI has, not you alone, and your balance alone may exceed it. And which state's law applies depends on where the QI is located, where the property sits and where you live, which isn't always clear. State statutes and requirements change, so ask your QI which ones it complies with and confirm the current text if it matters to your decision.

The industry has a trade association, the Federation of Exchange Accommodators, which publishes a code of ethics and offers a Certified Exchange Specialist designation. Membership and certification tell you the firm takes the work seriously. They aren't a substitute for checking how your money is held.

What happened when qualified intermediaries failed?

Three failures from 2007 and 2008 shaped how I think about QI selection. Each one failed differently, and each points to a different question you should ask.

The 1031 Tax Group (theft by the owner). Edward Okun bought a series of exchange companies and used client exchange funds for his own purposes. The companies collapsed in 2007. According to the FBI, about $126 million in client funds was misappropriated. A federal jury in Richmond, Virginia, convicted Okun on March 19, 2009, of mail and wire fraud, money laundering and related charges, and on August 4, 2009, he was sentenced to 100 years in prison. The lesson: when the owner controls the money, internal controls and employee-theft bonds may not help. A fidelity bond typically covers dishonest employees; whether it covers the owner is a separate question.

LandAmerica 1031 Exchange Services (investment and liquidity risk). This wasn't a fraud. LandAmerica's exchange subsidiary was owned by a large, publicly traded title company. It invested part of its customers' exchange funds in auction-rate securities, which became illiquid when that market froze in 2008. The subsidiary filed for bankruptcy in late November 2008. A Richmond business publication reported that about 450 exchangers were trying to recover roughly $420 million, and that the company held about $290 million in auction-rate securities as of early 2008. The bankruptcy court ruled that the exchangers were unsecured creditors, because the exchange agreements didn't create a trust or escrow and the funds had been commingled. Exchangers lost access to their money, missed their deadlines and waited in line with other creditors. The lesson: a well-known parent company isn't protection. What matters is how the funds are invested and whether they're legally yours or the QI's.

Vesta Strategies (a smaller collapse). A San Jose exchange company, Vesta collapsed in July 2008 owing about $25 million to exchange customers, and its principals were later sentenced to prison. It's a reminder that failures haven't been limited to one firm or one cause.

After these failures, the IRS issued Revenue Procedure 2010-14, which gives limited relief to exchangers whose QI went into bankruptcy or receivership. If you meet its tests, including having properly identified replacement property and having no actual or constructive receipt of the funds before the failure, you can report gain only as you actually recover money from the QI's estate, insurer or others, similar to the installment method. That helps with the tax timing. It doesn't get your money back.

How should my exchange funds be held?

This is the question I'd spend the most time on, because it determines what happens if your QI fails.

Commingled (pooled) accounts. Many QIs hold client funds in one or more pooled accounts in the QI's name, tracking each client's balance on internal records. This is efficient and lets the QI earn interest on larger balances. The risk is the LandAmerica risk: if the QI fails, a court may treat the pooled funds as the QI's property, and you become a creditor.

Segregated accounts. Some QIs open a separate account for each exchange, often titled to the QI for the benefit of the exchanger and using the exchanger's taxpayer ID so the interest is reported to the client. Your money isn't mixed with other clients' money, and it's easier to trace.

Qualified escrow accounts and qualified trusts. The regulations, in §1.1031(k)-1(g)(3), describe a qualified escrow account or qualified trust: an account held by an escrow holder or trustee who isn't you or a disqualified person, under a written agreement that limits your access to the funds as (g)(6) requires. Combined with a QI, a qualified escrow or trust adds a second layer: the money sits with an independent bank or trust company, and the QI can't move it alone.

Dual-signature or dual-authorization accounts. The strongest setup I see is a segregated account that requires both your written authorization and the QI's to release funds. The QI can't send your money anywhere without you, and you can't take it without the QI, which preserves the safe harbor. Several state laws require dual authorization for larger withdrawals.

Here's how I'd rank the options from the exchanger's point of view, strongest first:

A dual-signature segregated account may cost more or pay less interest. I think it's worth it on any balance large enough that losing it would change your life.

FDIC coverage. Bank deposits are insured up to $250,000 per depositor, per bank, per ownership category. A $1.5 million exchange balance in one bank account is mostly uninsured. Some QIs spread balances across banks or use deposit programs that do so, and some hold Treasury bills. Ask what the QI does, and ask where your specific funds will sit.

Who gets the interest on my exchange funds?

The exchange agreement decides, and you should read that part. The regulations allow you to receive interest or a growth factor on the funds, under §1.1031(k)-1(g)(5), as long as the agreement restricts your access under (g)(6). The interest is taxable to you as interest income; it isn't part of the deferred gain.

The tax rules for who reports the earnings are in Treasury Regulation §1.468B-6, finalized in 2008. Generally, exchange funds are treated as loaned by you to the QI, and the QI reports the earnings, unless the exchange agreement provides that all the earnings are payable to you, in which case you report them. If it's treated as a loan, the below-market loan rules can impute interest to you unless the QI pays enough interest, with an exception for exchange funds of $2 million or less held for six months or less.

In practical terms, some QIs pay you most of the interest, some pay a fixed rate and keep the rest, and some pay little or nothing and charge a lower fee. When rates are low, the difference is small. When short-term rates are meaningful, it isn't. On $1,500,000 held for 120 days at a hypothetical 4% annual rate, the interest is about $19,726. If the QI keeps all of it, that's effectively a fee far larger than the quoted one.

Ask:

• Will my funds earn interest, and at what rate or by what formula?
• Will it be paid to me, reported under my taxpayer ID on Form 1099-INT, and when?
• Does the QI keep a spread, and how large?

What should a qualified intermediary cost?

For a standard delayed exchange with one property sold and one bought, the quotes I see are generally in the low thousands of dollars. Expect added charges for more than one relinquished or replacement property, for wires and overnight delivery, and sometimes for early release or cancellation. Reverse exchanges and improvement (build-to-suit) exchanges cost substantially more, because an exchange accommodation titleholder has to take title to property under Revenue Procedure 2000-37, often through a new entity, and the work and liability are far greater.

Most tax advisors treat the QI fee as an exchange expense that can be paid from exchange funds. I go through which costs can and can't be paid from the exchange account in 1031 Exchange Costs and Fees.

My view on price: the fee range across reputable QIs is narrow, and the risk range is wide. I'd pay a few hundred dollars more for a segregated, dual-authorization account and clear answers about the bond every time.

What questions should I ask a qualified intermediary?

Here's the list I give owners. Ask for the answers in writing.

About the money

1. Will my funds be held in a segregated account or a pooled account?
2. Whose name and taxpayer ID will be on the account?
3. Does withdrawal require my written authorization as well as yours?
4. Will the funds be in a qualified escrow account or qualified trust with an independent bank or trust company?
5. Which bank or banks will hold my funds, and how is FDIC coverage handled above $250,000?
6. How are the funds invested? Are they ever invested in anything other than bank deposits, money market funds or Treasury bills?
7. What interest will I receive, how is it calculated, and how is it reported?

About protection

8. What fidelity bond do you carry, in what amount, and is the limit per claim or aggregate across all clients?
9. Does the bond or crime policy cover theft by owners and principals, not just employees?
10. What errors-and-omissions coverage do you carry, and in what amount?
11. Are your financial statements audited by an independent CPA firm, and will you share the most recent opinion letter?
12. Which state QI laws do you comply with, and are you licensed where licensing is required?

About the firm

13. How long has the firm operated, and who owns it?
14. Are you affiliated with my real estate broker, attorney, CPA or any other party to the transaction?
15. Who will handle my exchange day to day, and what's their experience?
16. Has the firm or any principal been the subject of regulatory action, litigation over exchange funds, or a bankruptcy?

About the agreement

17. What are the full fees, including wires, extra properties, early release and cancellation?
18. What exactly do I need to do to identify property, and what format and delivery method do you accept?
19. How do you verify wiring instructions, and how will you communicate them to escrow?

If a QI won't answer the account and bond questions directly, I'd move on.

What should I do on day one?

"Day one" starts before your sale closes. Once the relinquished property closes and proceeds reach anyone other than a QI, it's too late to set up the exchange. Here's the order I'd follow:

1. Choose the QI when you sign the sale contract, not the week of closing. It gives you time to ask the questions above and gives the QI time to coordinate with escrow. Many purchase contracts include a cooperation clause for a 1031 exchange; if yours doesn't, add one.
2. Sign the exchange agreement before the relinquished closing. The agreement has to be in place, and your rights in the sale contract assigned to the QI, with written notice to the buyer, on or before the closing date.
3. Give escrow the QI's instructions and confirm them by phone. Wire fraud aimed at real estate closings is common. Confirm any wiring instructions by calling a number you already know, not one in an email.
4. Make sure the proceeds go directly to the QI. Don't take a check, even one payable to the QI, and don't let funds pass through your account.
5. Confirm receipt. After closing, get written confirmation from the QI of the amount received and the account it's in.
6. Calendar both deadlines. Day 45 is the deadline to identify replacement property in writing. Day 180 is the deadline to close, or the due date of your tax return for the year of the sale, including extensions, if that's earlier. Both are counted from the day the relinquished property transfers, and neither moves for weekends or holidays. If your sale closes late in the year, extend your return so you don't lose part of the 180 days.
7. Identify in the form the QI requires. Identification must be in writing, signed by you, unambiguously describe the property and be delivered to the QI (or another permitted party) by midnight of day 45. I cover the three-property, 200% and 95% rules in 1031 Identification Rules.
8. Keep title consistent. The taxpayer who sells should be the taxpayer who buys. If an LLC or trust holds the relinquished property, the same entity, or one treated as the same taxpayer for tax purposes, should take title to the replacement.

What mistakes do people make with QIs?

In my experience, these are the most common:

• Waiting too long. Owners call a QI after the buyer's funds are already in escrow and the closing is tomorrow. It can sometimes be done, but rushing removes your chance to evaluate the QI.
• Letting the closing agent pick by default. Escrow and title companies often have preferred QIs or affiliates. They may be fine, but you should ask the same questions.
• Using a disqualified person. A CPA, attorney or broker who has worked for you in the past two years can't serve, no matter how well they know the rules.
• Not reading the interest and fee terms. The quoted fee isn't the full cost if the QI keeps the interest on a large balance.
• Assuming state regulation protects them. Most states don't regulate QIs at all, and a bond shared across all clients may not cover a large loss.
• Asking for money early. Requests to borrow against or pull funds during the exchange period can put the safe harbor at risk, and a careful QI will refuse.

Risks and limitations

A qualified intermediary reduces one risk, constructive receipt, and introduces another: you're trusting a third party with your proceeds. No account structure or bond eliminates that risk, and past failures show that exchangers can lose access to their money for long periods and lose part of it. Revenue Procedure 2010-14 helps only with the timing of tax on a failed exchange.

If your replacement property is a Delaware Statutory Trust interest or another securities offering, the QI wires funds to the sponsor's closing the same way it would to a property closing, but the investment itself carries its own risks: illiquidity, possible loss of principal, distributions that are not guaranteed and can be reduced or suspended, reliance on the sponsor, fees and load, debt, limited control, and tax-law change. Those offerings are available only to accredited investors through a private placement memorandum.

This guide isn't tax or legal advice. Confirm the structure of your exchange with a CPA or tax attorney, and review the exchange agreement before you sign it.

Frequently asked questions

Can my real estate attorney act as my qualified intermediary?

Not if they've acted as your attorney in the two years before you transfer the relinquished property. Treasury Regulation §1.1031(k)-1(k) treats your attorney, accountant, real estate agent or broker, investment banker or broker, and employees within that window as disqualified persons. The only exceptions are services performed solely for 1031 exchanges and routine services from banks, title companies and escrow companies. An attorney who has never represented you, and isn't related to you or your agents, could serve, but most owners use a dedicated QI.

Is my money insured while the qualified intermediary holds it?

Only partly, and it depends on the setup. Bank deposits are FDIC-insured up to $250,000 per depositor, per bank, per ownership category, which a typical exchange balance exceeds. A QI's fidelity bond and errors-and-omissions policy may cover theft or mistakes up to their limits, which can be shared across all clients. Ask which bank holds your funds, how deposits above $250,000 are handled, and what the bond limit and exclusions are.

Can I choose a qualified intermediary in another state?

Yes. Your QI doesn't have to be in the same state as you or the property. Many work nationwide by wire and electronic signature. Check whether your state or the QI's state has a QI statute, and whether the QI is licensed or bonded where required. Nevada and Maine require licenses, and a few others impose bonding and account rules.

What happens to my 1031 exchange if my qualified intermediary goes bankrupt?

Your funds may be frozen in the bankruptcy, and if the account was commingled, a court may treat you as an unsecured creditor, as happened to LandAmerica's exchange customers in 2008. You'll probably miss your deadlines. Revenue Procedure 2010-14 lets qualifying exchangers report the gain only as they actually recover money from the QI's estate, insurer or others. It doesn't restore the exchange or promise any recovery.

Do I get a 1099 from my qualified intermediary?

Usually. The closing agent reports the sale of your relinquished property on Form 1099-S. If the exchange agreement pays you interest on the funds, the QI generally reports it on Form 1099-INT. Neither form means the exchange was taxable. Your CPA reports the exchange itself on Form 8824 with your return.

Can I switch qualified intermediaries in the middle of an exchange?

It's rarely done and can be risky. The funds would have to move from one QI to another without ever being available to you, under agreements that preserve the (g)(6) restrictions. If you have a real concern about a QI's solvency, talk to a tax attorney immediately. The better answer is to choose carefully before the relinquished property closes.

Can a bank be a qualified intermediary?

Yes. A bank or a bank's exchange subsidiary can serve, and routine banking services don't make a bank a disqualified person. Some owners prefer bank-affiliated QIs because the parent is regulated. The bank-owned structure doesn't by itself protect your funds, though, so ask the same questions about segregated accounts, bonds and investment policy that you'd ask any QI.

Does the qualified intermediary need to be in place before I sign the purchase contract for my sale?

No, but it must be in place before the sale closes, with the exchange agreement signed and your sale contract assigned, and written notice given to the buyer, on or before the closing date. I'd line up the QI when you sign the sale contract so you have time to vet it and add an exchange cooperation clause to the contract.

If you're starting an exchange and want a second opinion on a QI's answers, I'm happy to go through them with you, and you can request access to the investor portal if you're considering replacement options.

Sources

• 26 CFR §1.1031(k)-1, Treatment of deferred exchanges (Cornell LII)
• 26 CFR §1.468B-6, Escrow accounts, trusts, and other funds used during deferred exchanges (GPO)
• Iowa State University Center for Agricultural Law and Taxation, IRS Issues Final Regulations on Like-Kind Exchanges
• Iowa State University Center for Agricultural Law and Taxation, The Perils of a Tax-Deferred Exchange When the Qualified Intermediary Goes Bankrupt (Rev. Proc. 2010-14)
• FBI Richmond, Business Owner Sentenced to 100 Years (Edward Okun, 1031 Tax Group), August 4, 2009
• Richmond BizSense, How Much Will LandAmerica's 1031 Customers Recover? (May 13, 2009)
• Foster Garvey, Failure of IRC 1031 Exchange Qualified Intermediary Highlights Risks
• Investors Title, State Regulation of Qualified Intermediaries
• Idaho Department of Finance, Escrow Act FAQs (application to QIs)
• Crowdfunded Wealth, 1031 Qualified Intermediary: State Laws and QI Failures (secondary summary of statutes)