Investors in commercial real estate are able to defer capital gains taxes using a 1031 like-kind exchange. The process involves regulations and deadlines, making the role of the qualified intermediary imperative to the success of the exchange.
This article will answer the question of how and why a 1031 QI is necessary and what an investor should look for when choosing one.
How does a 1031 Exchange benefit the investor?
Getting the most out of investment capital is one of the primary goals of most real estate investors. A 1031 Exchange allows the investor to use part of the sale, that would traditionally be used to pay capital gains tax, to reinvest in a like-kind replacement property. Continuing to reinvest into real property allows the investor to indefinitely defer the capital gains tax liability.
Regardless of the various local and state tax laws that can affect the sale of a commercial property, an investor will likely lose more buying power to capital gains tax if they do not leverage the benefits of a 1031 exchange.
How might a 1031 Exchange negatively affect investment capital?
The 1031 exchange process follows strict rules required by the IRS or else the transaction will not be allowed. Investors need to be aware of rules and follow them carefully to avoid unexpected capital gains taxes. These rules include the 45-day from closing to select an exchange property and 180 days from closing to complete the purchase of that property. Using an experienced 1031 exchange broker to facilitate the process will ensure you stay within the guidelines and that your transaction is approved without issues.
In worst case scenarios, an investor who fails to meet the IRS regulations or United States tax codes can lose over a third of their capital gain. Fully understanding the tenants of the tax code and strict regulations, such as the investor not being allowed to directly receive any funds from the sale, will ensure that there is no loss in investment capital.
What are the requirements for a Qualified Intermediary?
The QI must be insured and bonded
In the event that your QI makes a mistake, whether by accident, fraud, theft, or even forgery, you’ll want to be sure that you won’t be left paying for it. Honest mistakes can happen in any profession, and an honest professional will have safe-guards in place to protect their clients. Not only will the investor want to ensure that proper insurance is in place, they need to verify that the providing insurance agent is reputable and that there have been no gaps in the coverage. When so much capital gains investments are on the line, this sort of safeguard is non-negotiable.
The QI must not be an agent of the investor.
Due to the strict nature of the IRS’s guidelines regarding a 1031 exchange, not only can the investor not perform their own like-kind exchange, but no one that currently, or recently, serves as an agent of the investor may act in such a position. The IRS has also made the definition of what constitutes an agent as broad as possible. This means that anyone who might act on behalf of the investor could easily be classified as an agent of the investor, and thus rendering the 1031 Exchange as unacceptable. Avoiding the use of a non qualified intermediary removes any doubt that the person performing the 1031 exchange is in no way an agent.
There are some IRS granted exceptions to this rule. In fact, if any professional performing any sort of financial service for the investor was automatically disqualified, then the QI would also be disqualified. Certain caveats had to be made, and in doing so the role of the IRS qualified intermediary may also provide the following services to the investor:
- Insurance services
- Trust services
- Escrow services
- Routine financial services
Furthermore, other than the fees for performing the actual exchange services, the QI must not receive any other financial benefit as a result of the like-kind exchange.
The investor will want to ensure that the 1031 Qualified Intermediary has the experience to understand what additional services, and how recently they were provided, will constitute whether or not a QI might also be considered an agent of the investor.
The QI must have appropriate account structuring
Not only should the investor’s funds be fully insured against mistakes, a QI should also hold the funds in a separate account that is not tied to other accounts, or exist in an account shared with other investors’ capital. This ensures that there is no chance the funds may be compromised and in turn causing a like-kind exchange to be incomplete or the process extended beyond the regulated time-line. A proper trust or escrow account must be used, which protects the investor in any instances that the QI may file bankruptcy.
The QI may gain interest on investments held in appropriately structured accounts, but any interest gained during the process of holding the investor’s funds must be considered as part of the 1031 like-kind exchange service fee.
The QI is absolutely critical to the 1031 Exchange process
Commercial real estate investment is an industry that is undoubtedly seeing growth. With this growth comes an increasing demand for experienced like-kind exchange professionals. It does not take a savvy investor to realize the potential capital gains of the 1031 Exchange process, and a wise one will fully understand the importance of choosing a trustworthy QI.
Between U.S. tax codes and strict IRS rules, it is paramount to have a professional that can navigate the documentation process, complex regulations, codes, and the secure movement of your investment funds.
The choice of a QI should not be taken lightly by an investor, and we at Preferred 1031 welcomes the opportunity to answer any questions an investor may have regarding the 1031 Exchange process.
At what point in the process should an investor look for qualified intermediary services
The very moment an investor considers a 1031 like-kind exchange they should begin looking for an expert to perform the service. Why? Due to the strict regulations and time-lines imposed by the IRS, it is imperative that your exchange professionals are at the ground floor, guaranteeing a successful exchange that is legal and maximizes investment capital.
Choosing a QI at the last minute will not only increase the risk of mistakes being made and the like-kind exchange becoming disqualified, it won’t give the investor time to properly vet the qualified intermediary and establish their expertise in the areas outlined in this article.
How to find a qualified intermediary
If you are considering a 1031 like-kind exchange and have questions, do not hesitate to contact us at 866-293-1031 or info@preferred1031.com. We are happy to answer your questions and walk you through the process.