When you sell real estate, if there is a gain and the property was depreciated, capital gain taxes are due and recapture of depreciation. For many investors, this cuts into profits and dampens purchasing power—the more you pay in capital gains, the less you have to invest in a new piece of real estate. With a 1031 exchange, you can defer capital gains and reinvest all of the proceeds in a new property. The catch is the IRS provides guidelines and procedures that must be followed in an exchange and the IRS recommends using a qualified intermediary for 1031 exchanges; learn why this is your best bet.
What is a Qualified Intermediary?
A qualified intermediary is a neutral third party who helps complete a 1031 exchange. In a 1031 exchange, the qualified intermediary officially enters into a written agreement with the taxpayer to transfer the real property the individual wants to sell, then transfers the replacement property it to the taxpayer.
In other words, a qualified intermediary is someone who acts as a stand-in for you in two real estate transactions (the purchase and the sale) and transfers the acquired property to your name. If the exchange is done properly, you owe nothing in capital gains.
There are several valid reasons for choosing a qualified intermediary for 1031 exchanges, including:
Neutral Third Party
While you may think it makes sense to use someone who is familiar with your business interests, such as your lawyer or accountant, the IRS looks poorly upon this practice for 1031 exchanges. Attorneys, CPAs, real estate agents, and others who have acted on your behalf are disqualified from serving in this capacity.
Nor does the IRS allow you to use immediate relatives in 1031 exchanges, since these people have a clear interest in protecting your assets. While you are not technically prohibited from using in-laws, aunts and uncles, or cousins in this capacity, it's simply not recommended since doing so would invite disaster on many fronts.
Just as blood relatives are prohibited, so too are corporate entities which are majority owned by the individual who seeks a 1031 exchange. Thus, you cannot use a corporation which you own 51 percent of to act as a qualified intermediary in the 1031 exchange.
The IRS has strongly preferred safe harbors for these types of transactions and a qualified intermediary is the classic example of a safe harbor, according to the IRS Regulations. Most people who do 1031 exchanges use a qualified intermediary because of the strong preference by the IRS.
A qualified intermediary understands tax codes in this regard and can guide you throughout the process. Even the most basic transaction has layers of complexity that a lay person would not understand. It's simply smart to use a qualified intermediary, as they prevent you from making mistakes that would have long-term consequences.
What Does a Qualified Intermediary Do?
A qualified intermediary will work in tandem with other vested parties, from the title company who is issuing insurance to the escrow company closing the transaction. The qualified intermediary together with these other parties facilitates the sale, purchase, and asset transfer. A good qualified intermediary will be there throughout the entire process, demystifying the 1031 exchange and answering any questions that arise.
How to Find a Qualified Intermediary
When you are turning over your assets to someone to complete a 1031 exchange, trust is essential. So how do you find a qualified intermediary who can help?
Referrals through escrow and real estate agents are one way to identify qualified intermediaries, so start by asking your agents who they would recommend. CPAs, financial advisers, and attorneys may also be able to refer you to someone.
Once you've received referrals, look for a qualified intermediary who stands out as professional -- someone who is a thought leader in the area. Companies that host educational webinars on the issues not only demonstrate leadership in the field but provide contextual information for individuals who are in the process of evaluating whether a 1031 exchange will be beneficial.
Some companies, such as Exchange Resources, give classes that introduce common issues with 1031 exchanges, translating tax code issues for lay people. By attending a class, you can get your questions answered and come to know the person that will serve as a qualified intermediary.
You can also built a rapport with the company who will serve as qualified intermediary. If you like and trust the company, then it makes sense to hire them as qualified intermediary.