THE ROLE OF THE QI
The most common exchange format, the delayed exchange, requires investors to work with an IRS approved middleman called a “Qualified Intermediary” (QI) who facilitates the exchange; and is further defined as follows:
Not a related party (i.e. agent, attorney, accountant, investment banker, broker, or real estate agent, etc.);
Receives a fee;
Receives the relinquished property from the exchanger and sells to the buyer;
Purchases the replacement property from the seller and transfers it to the exchanger.
The QI does not provide legal or specific tax advice to the exchanger, but will usually perform the following services:
Coordinate with the exchanger and their advisors (i.e. attorney, accountant, realtor etc.) to structure a successful exchange;
Prepare the exchange documentation for the Relinquished Property and the Replacement Property;
Furnish escrow with instructions to effect the exchange;
Secure the funds in an insured bank account until the exchange is completed;
Provide documents to transfer Replacement Property to the exchanger, and disburse exchange proceeds to escrow;
Provide documentation to the exchanger at completion of the exchange necessary to complete their required tax reporting.
WHAT IS A 1031 EXCHANGE?
The concept of Section 1031 has been on the books since 1921 and is one of the last significant tax advantages remaining for real estate investors. The key advantage of a Section 1031 exchange is the ability to sell a property without paying any capital gain tax, or depreciation recapture at closing, which allows the earning power of the deferred taxes to work for the benefit of the investor.
Although Section 1031 refers to “an exchange of property”, it does not require a simultaneous “swap” of properties. One of the most significant rule changes occurred as a result of the 1979 Starker decision in which the Court of Appeals enabled the non-simultaneous or “delayed” exchange to qualify for tax deferral. This gave investors the time necessary to find desirable replacement property. In 1991, the IRS described how to convert a sale and subsequent purchase of property (or “delayed” exchange) into a tax deferred exchange by employing what the IRS calls a “Qualified Intermediary” (also referred to as a Facilitator or Accommodator).
WHAT IS A QI?
A Qualified Intermediary “QI” is an entity who enters into a written agreement with the taxpayer (“exchanger”) to acquire the exchanger’s rights and/or ownership interest in the property the exchanger is selling (“relinquished property”), and transfer such ownership interest into one or more properties of “like-kind” that the exchanger chooses to buy (“replacement property”). A QI is required by tax law and provides a safe harbor for the taxpayer (exchanger).
In other words, the intermediary is “assigned in” as the seller of the property during the closing process. It is the assignment that allows the seller to become an exchanger, and, essentially, convert an otherwise taxable sale and subsequent purchase of investment real estate into a tax-deferred exchange.
Because the intermediary is technically the seller who receives the sale proceeds, it prevents the exchanger from being in “actual or constructive receipt” of the proceeds; thus, there is nothing to tax.
BASIC REQUIREMENTS
Although Section 1031 refers to “an exchange of property”, it does not require a simultaneous “swap” of properties. One of the most significant rule changes occurred as a result of the 1979 Starker decision in which the Court of Appeals enabled the non-simultaneous or “delayed” exchange to qualify for tax deferral. This gave investors the time necessary to find desirable replacement property. In 1991, the IRS described how to convert a sale and subsequent purchase of property (or “delayed” exchange) into a tax deferred exchange by employing what the IRS calls a “Qualified Intermediary” (also referred to as a Facilitator or Accommodator).
A Qualified Intermediary “QI” is an entity who enters into a written agreement with the taxpayer (“exchanger”) to acquire the exchanger’s rights and/or ownership interest in the property the exchanger is selling (“relinquished property”), and transfer such ownership interest into one or more properties of “like-kind” that the exchanger chooses to buy (“replacement property”). A QI is required by tax law and provides a safe harbor for the taxpayer (exchanger).
In other words, the intermediary is “assigned in” as the seller of the property during the closing process. It is the assignment that allows the seller to become an exchanger and, essentially convert an otherwise taxable sale and subsequent purchase of investment real estate into a tax-deferred exchange.
Because the intermediary is technically the seller who receives the sale proceeds, it prevents the exchanger from being in “actual or constructive receipt” of the proceeds; thus, there is nothing to tax.
CHOOSING A QUALIFIED INTERMEDIARY
A QI should be investigated for their experience, background and credentials. They should have extensive real estate and 1031 Exchange knowledge and expertise.
Due to the complexity of the 1031 Exchange, it is in the best interest of the exchanger to hire a QI that is a Certified Exchange Specialist™. This designation demonstrates that the QI possesses a higher level of knowledge and experience and passed the national examination administered by the Federation of Exchange Accommodators (FEA), a national organization for qualified intermediaries. A person who receives the CES™ is required to uphold a strict Code of Ethics and must meet continuing education requirements to retain this designation.
DEALER VS. INVESTOR
The IRC Section 1031 Rules and Regulations specifically state “No like-kind exchanges for “dealers” in real estate, only “investors”. Dealers in real estate may not use the like-kind exchange provisions regarding non-recognition of gain or loss on exchange of real property because they hold real property as stock-in-trade (inventory), and not for productive use in business or for investment (Section 1031(a)(2)).”
“An ‘investor’ or ‘speculator’ in real estate is usually anticipating a gradual appreciation in value of the real estate, or a rather sudden increase in value in the event of fortuitous circumstances, without doing much to cause that increase in value; whereas the ‘dealer’ in real estate is typically looking for a rapid increase in price over a relatively short time, most frequently as a result of some efforts on their part to cause the increase. Unfortunately, these categories are only the extremes and do not cover the entire spectrum of real estate transactions. Those that fall in between are the most difficult to characterize for tax purposes.”
Klarkowski v. Commissioner, T.C. Memo 1965-378.