Real estate owners can legally defer capital gains taxes with a 1031 exchange. In delayed exchanges, which are the most common, Qualified Intermediaries receive the funds from the sale of the relinquished property and forward them for the acquisition of the replacement property. (Reverse 1031 exchanges also require Qualifies Intermediaries.)
This article answers the following questions:
Why are qualified intermediaries necessary for 1031 Exchanges?
Who can and cannot serve as a qualified intermediary?
What should an investor look for in a qualified intermediary?
Why are qualified intermediaries necessary for 1031 Exchanges?
If an exchange does not comply with certain tenants of the U.S. tax code or IRS regulations, the IRS will treat it as a taxable sale and an investor may lose 20–35% of their capital gain as a result. One of these rules specifies that if an investor receives any of the funds from the sale directly (actual receipt) or even receives control of those funds (constructive receipt), the money becomes taxable. The regulations are pretty strict about what counts as “constructive receipt” of funds—for example, even the delivery of a physical check that never gets cashed may count as “constructive receipt”, which would render that money taxable.
While this rule may be simple enough to comply with in the case of a simultaneous exchange, which only requires one escrow, such cases are rare and difficult to coordinate. Most 1031 exchanges are delayed, or “Starker”, exchanges, which allow for two closings: one for the disposition of the original property and a subsequent closing for the acquisition of the replacement property.
In order for an investor to avoid receiving funds from the sale of their original property, federal regulations allow the proceeds to be held by a third party—the “Qualified Intermediary” or “QI”. This way the investor defers the receipt of any capital gain, and therefore defers the recognition of any gain on their taxes.
Qualified Intermediaries can sometimes be referred to as a “Facilitators” or “Accommodators”, and they typically support investors throughout the entire 1031 exchange process, helping them with all the necessary tax and legal paperwork required for a successful exchange.
It’s important for investors to be aware of the federal requirements that relate to Qualified Intermediaries so they can know what to expect during the exchange. Investors are ultimately the ones who will be held responsible for their property and any tax obligations that result from its disposition. Not only that, but the federal government does not require Qualified Intermediaries to obtain any special license in order to do business, and they do not actively supervise them to make sure they are complying with federal regulations and treating investors fairly. It is up to investors to make sure they understand the law and select a reputable QI in order to avoid unnecessarily high tax bills (or fraud). In reality, most QIs are reliable, and with a just little bit of education an investor can successfully carry out a 1031 exchange without any worry.
In a 121 exclusion, however, the homeowner does receive the proceeds from the sale of their personal residence, yet they do not need to pay taxes on any capital gains (up to a certain amount). While a 1031 exchange defers capital gains taxes, a 121 exclusion shelters capital gains from being taxed altogether. There is no limit to the total number of times a taxpayer can take the Home Sale Exclusion, so long as the requirements are met.
