Many property owners looking to perform 1031 exchanges choose their QIs based on who’s close or who’s cheap, not realizing that the wrong decision could invalidate an exchange.

For more than a century, property owners have been able to defer taxes on the sale of business or investment property through IRC Section 1031 like-kind exchanges. A 1031 exchange can be a powerful tool for small businesses and help individuals plan for retirement. By deferring capital gains taxes, depreciation recapture, and certain other taxes, it’s possible to invest more in your future and build greater wealth.

For a 1031 exchange to be valid, the exchanger cannot have control over, or benefit from, the proceeds of their relinquished property sale during the exchange period. After selling your relinquished property, you normally have 180 days to purchase a like-kind replacement property, but that doesn’t mean you can simply sell one property and purchase another – it’s vital that you not take receipt of the funds involved in the exchange until after the exchange is complete.

This is accomplished through the use of a Qualified Intermediary (QI), a third party that serves as custodian of the sales proceeds during the exchange. It’s the QI’s responsibility to make sure the exchanger does not take receipt of funds and that those funds are secure until they can be deployed to purchase the replacement property.

That may seem simple enough, but there is a lot that can go wrong during an exchange. Mistakes made by QIs can lead to exchanges being deemed invalid, resulting in considerable tax liabilities and ruining exchangers’ investment strategies. Despite this, more often than not, selecting a QI seems to be treated as an afterthought. Many exchangers simply search for the closest QI in their area or one that offers the lowest price, use a bank or title company involved in the transaction, or try to save money by asking a friend or neighbor to do it.

Even though IRC Section 1031 involves a lot of rules, there are essentially no federal regulations for QIs. Because the industry is largely unregulated, all of the above scenarios could be allowed, but could also lead to real trouble. If you don’t understand why you need a QI that offers certain protections, or why it matters who does this job at all, here are a few reasons why choosing the wrong QI can cost you big.

The dangers of selecting the wrong Qualified Intermediary

Any time your hard-earned money is at stake, you want to work with experienced professionals. As JTC National Sales Manager and 1031 specialist Justin Amos said on a real estate podcast about 1031, “Even though the 1031 exchange has been in the tax code for now over 100 years, it’s still a specialized transaction.”  Your CPA or real estate agent might have only done a few 1031 exchanges in their career, and might never have seen a situation exactly like yours. That’s a far cry from the many tens of thousands of exchanges the team at JTC has seen; we know how exchanges can go wrong.

“The Qualified Intermediary industry is still an unregulated industry, so there’s not a set of rules or regulations that each QI needs to follow,” cautioned Amos. That means that even if you select a QI that promises a successful track record, the only way to be sure they’re doing the right things to protect your capital is to understand what a QI should be doing and perform your own due diligence.

One way QIs can put their clients’ exchanges at risk is by commingling funds. Instead of keeping each exchanger’s funds in a separate bank account, they just add the funds to their general business account, without keeping track of which funds belong to which client and which funds can be used for other purposes. If your QI invests your exchange funds into an investment that can’t be redeemed in time for your 1031 exchange deadline, you could miss your chance to complete your exchange in time because the funds weren’t made available when you needed them.

If your QI isn’t a reputable business but instead a family friend or acquaintance, there’s always the risk that person could steal some or all of your exchange funds. Thanks to greater oversight and an industry commitment to best practices, this type of misappropriation isn’t as common as it once was. But there are still over $1 billion worth of examples of exchangers who trusted the wrong person and ended up losing their entire investment, so it’s worth your time to be as cautious as possible and check your QI’s record.

A common mistake that can lead to exchange failure is when the QI allows the exchanger to take receipt of the sales proceeds before the exchange is complete. As soon as the taxpayer takes “actual or constructive receipt” of exchange funds or takes title to the replacement property, the exchange is over. That’s why you need a QI, and why the QI must be a third party, with the money in an account not controlled by the exchanger.

You’ll not only need to carry out this arrangement, but prove it when you file your taxes, which is why you need a proper written agreement with your QI, and thorough records regarding how and where funds were held and when and how they were transferred. By not working with a seasoned professional, you risk performing these steps improperly and ruining the work you put into setting up the exchange.

It’s also important to note that there are other exchanges beyond the standard forward exchange. A less-experienced QI may not be familiar with Delaware Statutory Trusts (DSTs), state-to-state exchanges, reverse exchanges, or other nuanced iterations of an exchange. Sometimes rules change, and if you work with someone who isn’t up to date on the latest IRS revenue procedures, you’ll be the one who has to face the unfortunate consequences.

What happens when a QI makes these mistakes

The rules surrounding 1031 exchanges, particularly the timeline, are quite strict. If 45 days passes from the closing date of the relinquished property sale and you haven’t identified your replacement properties, the exchange has failed. If 180 days has passed and you haven’t acquired one of those identified replacement properties, the exchange has failed. And once you take receipt of your exchange funds or title to the replacement property, even if it’s before Day 180, it doesn’t matter – the exchange is over.

The IRS has no sympathy for those who made a mistake and chose the wrong QI. You can’t ask for a do-over because the QI commingled your funds and didn’t release them to the replacement property seller in time. Once an exchange has failed, it’s failed. And if the QI hasn’t kept proper records, what you thought was a successful exchange could be deemed invalid after the fact.

If that happens, you’ll be taxed for capital gains, depreciation recapture, and any other state and local taxes you may have deferred depending on where you live. Being forced to pay taxes you thought you were going to be able to defer is bad enough, but for those who already used their full sales proceeds to purchase a replacement property because they thought their exchange would be valid, there is an additional worry: if the tax burden from your property sale exceeds your liquid assets, you could be forced to sell additional assets, or even your replacement property. Depending on the property and the investment strategy you had in mind (for example, if you’d hoped to hold this 1031 property until your death so your heirs could take advantage of the step up in basis), one failed exchange could end up costing you millions.

“A good team that supports you is ultimately going to lead to success,” said Amos on his podcast appearance. “It could be very expensive to make the wrong choice.”

What to look for in a QI – 1031 best practices

We’ve discussed why it’s important to avoid choosing the wrong QI. So how do you choose the right QI? Section 1031 of the tax code is complex enough on its own; with a lack of any federal guidelines on the unregulated QI industry, it can be difficult to distinguish disreputable practices from safe operating procedures.

That’s why JTC has long been an advocate of best practices in the Qualified Intermediary industry. We’ve pioneered a set of standards by which you can judge whether or not a QI has implemented the necessary procedures to prevent the loss or misuse of your funds. Our best practices for 1031 exchanges includes such measure as:

• The QI should never be on the title when overseeing client funds
• Any fund movement should require dual authorization by both the exchanger and the QI
• Exchange funds should only be held in fully-liquid individual escrow accounts that are FDIC-insured, never commingled in operating accounts
• Errors and omissions and cyber insurance and a fidelity bond should be provided
• The QI should be willing to undergo annual third-party audits of their processes to demonstrate their security

A competent QI should also provide the exchanger with access to account information and the ability to view exchange status in real time. In addition, a dedicated staff with experience in 1031 exchanges (and that can prove their claims about this experience, including relevant certifications) can add to investor peace of mind.

Property owners executing 1031 exchanges come in all shapes and sizes: some are large companies or DST sponsors that execute hundreds of exchanges a year; others are single-property investors who may perform one exchange every 30 years. Regardless of whether this is your first exchange or your 500th, you deserve the same security, transparency, and compliance measures from your QI, and one QI in the industry stands above the rest.

How a 15-minute phone call could save you millions of dollars

As Amos explained at a JTC webinar, one of the most important things you can do to set yourself up for a successful 1031 exchange is to choose the right QI, and do so before you sell your relinquished property.

“It’s definitely important to be speaking with a Qualified Intermediary as early as possible.” said Amos.

By selecting a QI that adheres to industry best practices and a provable track record of success, you can feel confident that your exchange funds are being held securely, and will be there when you need them. But that’s not the entire 1031 equation – you also need a QI that understands and can comply with all current IRS regulations, and one that can provide you with the documentation you need for your tax return.

That’s why JTC has created our Exchange Manager portal, which provides 24/7 access to account balances and locations during the exchange, as well as document storage and a full audit trail. You can securely access the password-protected portal from anywhere in the world to generate customized reports during and after the completion of your exchange.

JTC undergoes a yearly SOC 1 Type 2 audit to ensure the security of our processes and technologies, and complies with all necessary regulations, including the latest IRS rulings. Our expertise in 1031 is unmatched, especially when it comes to less-common exchange types like reverse exchanges, improvement exchanges, or exchanges for DST sponsors. The 1031 best practices mentioned above? We wrote that set of best practices, and adhered to them years before they became industry standard.

With JTC, you get an experienced QI with dedicated client service, industry-leading technology, and a commitment to providing the best experience possible for your 1031 exchange. Contact us today for a free, no-obligation consultation where we can learn about your exchange goals and tell you how we can help.

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