The IRS Code Section 1031 allows taxpayers an avenue of preferred tax treatment on the sale of qualifying property. Qualifying property is defined as property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. To benefit and maximize this tax treatment, taxpayers must stay within certain guidelines set forth by the IRS. These guidelines are defined as the "safe harbors" of a 1031 Tax Deferred Exchange. One of the key safe harbors of this tax benefit requires that taxpayers, not engaging in a simultaneous swap of property, utilize a third party intermediary to facilitate the exchange process.
The role of the intermediary is defined as an entity that enters into a written exchange agreement with the taxpayer to acquire and transfer the property relinquished, and to acquire the replacement property and transfer it to the taxpayer. This requirement limits the control and keeps taxpayers at arms length with regard to proceeds and property during the exchange period.
Taxpayers participating in this process are often doing so for the first time. Choosing the entity taxpayers entrust their funds and their property can oftentimes pose a challenging and apprehensive endeavor.
The best way to select a Qualified Intermediary (QI) of choice is through due diligence on behalf of the taxpayer. Considerations should include:
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The IRS Code Section 1031 clearly sets forth guidelines describing persons or entities that cannot qualify as an intermediary. These guidelines include:
- QI must be independent of the taxpayer
- QI cannot be the taxpayer
- QI cannot be employee of the taxpayer
- QI cannot be relative of the taxpayer
- QI cannot be attorney, tax advisor, real estate broker or investor if any of these professionals provided any other service creating an agency relationship within two years prior to the first property closing
- Does the QI carry a current, active Fidelity Bond? At what level? Consider a minimum of $1,000,000?
- Does the QI carry a current, active Errors and Omissions Policy? At what level? Consider a minimum of $1,000,000?
- Does the QI segregate client accounts? If not, why? How are funds earmarked throughout the exchange process? What exposure or liability to taxpayer funds if non-segregated?
- Does the infrastructure for the QI provide for dual control of all disbursements of taxpayer funds? This provision can limit potential for error and heighten security by ensuring more than one person/entity monitors and reviews all activity of taxpayer funds.
- Does QI notify taxpayer each time money enters or exits their account or for any activity on their account during the exchange period?
- Does QI return any and all interest earned to the taxpayer? At what rate?
- Is the QI owned by a licensed CPA or attorney?
Following these preliminary screening questions can help taxpayers gain a better sense of security in choosing the firm to facilitate their tax deferred exchange.
Once a QI enters into an exchange agreement with a taxpayer, there are certain fiduciary rules that pertain to taxpayer funds and property.
As a general rule in exchanges, the QI will disburse proceeds based on one of the following conditions:
- Taxpayer failed to identify any replacement property within the 45-day safe harbor window and the exchange has reached the 46th day.
- Taxpayer has received all replacement property to which he or she is entitled under the property identification form.
- Material and substantial contingency has occurred after the identification period has expired, said contingency being out of the control of the taxpayer, the occurrence relates to the exchange, and was provided for in writing.
The exchange agreement entered into between the QI and the taxpayer should list these situations as exceptions to the rule that the taxpayer does not have the right to receive, pledge, borrow, or benefit from the proceeds before the end of the exchange.
Practically speaking, these restrictions on disbursements apply to taxpayers in the following ways:
- Taxpayers may not expect any access to their proceeds within the first 45 days of the exchange except insofar as the QI may need to disburse some earnest money for a replacement property contract or the taxpayer may be ready to actually close on a replacement property.
- Taxpayers who have identified more than one replacement property may not ask the QI for a disbursement prior to the end of the exchange period or acquisition of all identified properties.
- Taxpayers cannot ask for an early disbursement because they changed their minds about buying a piece of property identified in a timely manner.
- Taxpayers may have access to their account if the identified property is destroyed by an Act of God (i.e., flood literally washing away the contracted-for property).
- Taxpayers may have access to their account if the seller of replacement property irrevocably breaches the contract after the identification period and there is insufficient time to cure the breach or sue for specific performance.
- Taxpayers may not have access to proceeds in order to pay a debt or purchase non-like-kind property.
This limited control over funds and/or property during the exchange is a key distinction between a straight sale and purchase and reaping the tax benefits of a like kind exchange.
