When you sell your investment real estate as part of a 1031 exchange, the sale proceeds are transferred to a Qualified Intermediary (QI), rather than to you.
That can mean entrusting hundreds of thousands or even millions of dollars to a company you may have never dealt with before.
Most investors spend considerable time evaluating the property they are selling and the property they are buying. Far fewer spend the same amount of time evaluating the company that will hold their money between those transactions.
Why the QI Holds Your Money
IRS rules provide a safe harbor for a deferred 1031 exchange when a Qualified Intermediary is properly used. The QI holds the sale proceeds while you complete the exchange.
The QI is an important part of the structure that allows you to defer the tax on your exchange rather than receiving the sale proceeds yourself.
QIs Are Not Regulated Like Banks or Broker-Dealers
There is no federal licensing system specifically for companies providing 1031 Qualified Intermediary services, and state requirements vary.
A QI therefore does not automatically operate under the same regulatory framework as a bank or broker-dealer. That makes the financial strength, fund-handling practices and safeguards of the individual QI important considerations when choosing one.
How Is Your Exchange Money Protected?
The most important part of choosing a QI is understanding how your exchange funds are held and protected.
Important safeguards can include segregated exchange accounts, qualified escrow or trust arrangements, controls over transfers, fidelity bonding, errors and omissions insurance, and financial strength or corporate backing.
Being told that your money is in a “segregated account” does not necessarily tell you everything about how it is protected. The account structure, ownership, control of the funds and terms of the exchange agreement can all be important.
LandAmerica: A Lesson for 1031 Investors
The risk of a QI failure is not theoretical.
In 2008, LandAmerica 1031 Exchange Services filed for bankruptcy while holding more than $400 million in exchange funds for approximately 450 customers. Some of the funds had been invested in auction-rate securities that became difficult to sell during the financial crisis.
The bankruptcy created a significant dispute over the customers’ exchange funds and became an important example of what can happen when a QI experiences financial problems.
The lesson is that the way a QI holds and controls exchange funds matters. Investors should understand how their money is held and what protections are in place before the exchange proceeds are transferred.
What Happens to the Money While the Exchange Is Open?
A 1031 exchange can take up to 180 days, so the QI may hold your proceeds for several months.
During that time, investors should understand whether their funds remain in bank deposit accounts or can be invested in other financial products.
Exchange funds need to be available when the replacement property is ready to close. Investments that can lose value or become difficult to sell can create additional risk.
Interest is another issue worth understanding. Depending on the QI and the account arrangement, exchange funds may earn interest while they are being held. The investor should know whether interest is paid to the investor, retained by the QI or handled in another way.
Financial Strength and Insurance Matter
The financial strength of the QI is another important consideration.
Look at who owns the company, how long it has been in business and whether there are substantial financial resources behind it.
Insurance and bonding can provide additional protection. A fidelity bond can address certain losses resulting from dishonest acts such as theft or embezzlement. Errors and omissions insurance can cover certain professional mistakes.
Internal controls are important as well. Procedures that limit who can initiate and authorize transfers can provide additional protection against fraud and unauthorized transactions.
Some QI professionals also hold the Certified Exchange Specialist® designation through the Federation of Exchange Accommodators. While a designation does not replace evaluating the company itself, it can be another piece of information to consider when researching a QI.
Don’t Automatically Use the QI Someone Recommends
Many investors are introduced to a QI by a real estate agent, attorney, CPA or investment professional.
A recommendation can be a useful starting point, but investors have a choice and can compare companies before selecting one.
If you are considering a Delaware Statutory Trust as replacement property, it is also important to keep the QI decision separate from the investment decision. The company holding your exchange funds should be evaluated based on its financial strength, fund custody arrangements and safeguards. The professional recommending your replacement investment should be evaluated separately based on their experience and qualifications.
Established QIs Give Investors Choices
There are many established companies providing 1031 Qualified Intermediary services nationally. Some of the better-known companies include:
- IPX1031
- Asset Preservation, Inc. (API)
- Exeter 1031 Exchange Services
- First American Exchange Company
- Accruit
Established QIs typically publish information about their financial safeguards, which can include fidelity bonds, errors and omissions insurance, corporate guarantees, segregated exchange accounts, transfer controls and other security procedures.
The amount and type of protection can vary from one company to another, so investors should compare the safeguards and financial strength of the QIs they are considering rather than simply accepting the first name someone recommends.
Review the QI Agreement Before Closing
Do not wait until the day your property closes to review the exchange agreement.
Read it beforehand and understand how it addresses your exchange funds, the QI’s authority over those funds, the account structure, interest earned on the funds and what happens if the exchange is terminated.
If you do not understand an important provision, ask your attorney or tax advisor to review it.
Don’t Choose a QI Based Only on Price
QI fees are small compared with the amount of money being held.
Saving a few hundred dollars should not be the primary reason for selecting the company that will hold hundreds of thousands or millions of dollars of your exchange proceeds.
Consider the company’s financial strength, ownership, experience, fund custody arrangements, insurance, bonding, internal controls and policies for handling exchange funds.
You Can Reconsider Your QI Later
If you used a QI for your original 1031 exchange and later own a DST as replacement property, you may have another opportunity to complete a 1031 exchange when the DST is sold, assuming the transaction qualifies.
You are not automatically required to use the same QI again. You can evaluate the company at that time and decide whether its protections and procedures still meet your standards.
Questions to Ask Before Choosing a QI
- Where and how will my exchange funds be held?
- What controls are in place to protect the funds from unauthorized transfers?
- What bonding and insurance does the QI maintain?
- Can the exchange funds be invested while they are being held?
- What happens to any interest earned on the funds?
- What happens to my funds if the exchange is terminated, or if the QI experiences financial problems?
The Bottom Line
Your Qualified Intermediary may hold a substantial amount of your money for several months.
Choosing one should involve more than accepting a recommendation or looking for the lowest fee. The LandAmerica bankruptcy showed why the company holding your exchange funds deserves careful consideration.
You do not need to assume that every QI is unsafe. You do need to understand the company you are trusting with your money.
Key Takeaways
- Understand how your exchange funds will be held and what safeguards are in place.
- Evaluate the QI’s financial strength, ownership, experience, insurance, bonding, and internal controls.
- Review the QI agreement before your property closes and understand how your exchange funds will be handled.
- Compare QIs rather than automatically using the company someone recommends.
- Do not choose a QI based solely on price when the company may be holding substantial exchange proceeds.
Qualified Intermediary Disclosure
NexTrend Securities does not provide or receive compensation for Qualified Intermediary services and is not associated with any particular Qualified Intermediary.
If you are considering a 1031 exchange or a DST as replacement property and would like to discuss your options, contact NexTrend Securities at (972) 661-1283
Have questions about DST investments?
NexTrend Securities works with accredited investors, providing DST investment options as replacement property in a 1031 exchange.
Call NexTrend Securities at (972) 661-1283
This article is provided for general educational purposes only and does not constitute tax, legal, or investment advice. DST investments involve risk, including illiquidity and potential loss of principal, and are suitable only for accredited investors. Tax treatment depends on individual circumstances. Consult your tax advisor regarding your individual situation. NexTrend Securities is not a tax advisor and does not provide tax advice.
We can help you make the most of your 1031 exchange.