1031 Property Exchanges: Keeping it Simple
In my last article, “…Don’t be Duped,” I promised to provide more insight into the 1031 exchange process. That article explained that there are many, many zealous companies out there that will gladly take your money and serve as your qualified intermediary. If you are a serious real estate investor, expecting to periodically trade property, you will undoubtedly be faced with the need to consider a 1031 exchange. The question: What to do about the QI?
If ever you became baffled by the massive legal and tax details described by typical 1031 qualified intermediary service companies, you’re not alone. I would expect that confusion is just what they’re counting on. The more confused you are, the more convinced you will be in using their “experts.” Heaven forbid the real secrets of 1031 exchanges should be divulged to the average real estate investor.
If you were a fly on the wall, overlooking the desk of a typical QI service provider, conducting a “forward exchange” of property (where the exchangor sells one property before purchasing the next), you would likely be amazed at just how little activity is involved for the QI. With that knowledge, you would also likely be appalled at the price tag of that service.
A typical process for a QI for a forward exchange goes something like this:
1. The QI receives the signed exchange agreement and files it.
2. The QI receives the money from the sale of your relinquished property in his escrow account.
3. The QI receives your list of identified replacement properties (within 45 days) and files it.
4. The QI sends the escrowed money to the seller of the replacement property as you direct him.
5. You pay his fee. Typically, $2,000 to $20,000 depending on the property you exchanged.
Is it really that easy? Yes, it is. Despite the extensive library of 1031 materials that you can obtain from their websites and other sources, nearly all will emphatically state that they provide no legal or tax counsel. That advice must come from your own advisors. You must discuss with them such questions as “How much “boot” will result in my exchange? or “Is this property “like-kind? etc. When those questions are answered and you’re ready for the exchange, then the QI steps in. The QI serves as the middle-man, essentially holding paperwork and money during the exchange period - nothing more. Yet often an exchangor will pay much less to his attorney or accountant, in answering the tough questions, than he will pay to the QI. I know. I’ve been there.
I’ve served on both sides of the transaction. In my practice as an attorney, I’ve actually provided (non-client) QI services and have also represented clients in transactions in which they’ve used other independent QI’s. What is particularly frustrating, is seeing the QI services price tag fluctuate wildly, depending upon the value of the exchanged property. Why should that be, when the process and paperwork is virtually identical for a $100,000 property or a $10,000,000 property? I believe it is because many are willing to pay the inflated fee, believing perhaps that they are getting some better protection for their very valuable asset. It’s simply not true. The process is the same. Following the very simple 1031 procedures gives the exchangor the very same protection, regardless of the property’s value.
Some have wondered, “Is it the “qualified” status of the intermediary that justifies the fee?” No. “Qualified” simply means “not disqualified.” The simple truth is, even your close friend or next door neighbor would likely be qualified to serve as your intermediary. How much would he or she charge you for the same service?
True story: I had recently discussed the 1031 process with another attorney acquaintance. He informed me that although he didn’t understand the process very well, his father, who is a real estate investor, very recently looked into the process regarding one of his transactions. He carefully weighed the decision to pay several thousands in capital gains taxes, versus paying several thousands to a QI. I don’t know what the final decision was, but I was told by the attorney that his father was quite frustrated at the dilemna in which he found himself. He knew that QI service fees were not justified, but he felt he had no alternative. How I wish I could have told him that an alternative does actually exist!
If you’re serious about real estate investing, you need to think seriously about your options when it comes to 1031 exchanges. Please, once again, don’t be duped!
I earned my J.D. 2 1/2 years ago, but I haven't been practicing. Although I studied taxation thoroughly in law school, I don't remember learning about a 1031 exchange. Thus, I have been actively seeking information on it.
I find Mr. Mayers comments very insightful. I agree, there should be a flat fee regardless of the price of the property.
Also, I wonder, does the Code or the Reg's describe what a "Qualified Intermediary" is? I am new to real estate investing and I have no experience with this, but based on this article, a QI sounds like an escrow agent to me. I am in Ohio where we have escrow closings.
Jennifer Miller
Jennifer
Thanks for the comment. It's not surprising that you don't recall a 1031 exchange. Although I expect that it was probably covered very briefly in your tax courses, it would not be something that would remain in the forefront of your mind unless it is used frequently.
The 1031 "deferred exchange" is used only as a means of deferring capital gains taxes. Thus, unless an investor holds an appreciable piece of property, the 1031 is not necessary. Real estate is probably the most widely used source. Other property like art, collectibles, etc will also be a good prospect. My use of the 1031 in my practice with aviation (corporate jets) comes and goes, depending upon the inflating or deflating market.
To answer your specific concern, the "qualified" intermediary is anyone that is not otherwise "disqualified". See IRC 1.1031(g)(4). As a lawyer, you may not act as a QI for your own client. However, I have served as QI for non-clients under an entity, separate and apart from my law firm.
There is a lot of free information available on the web regarding the 1031 process, however, I caution anyone reviewing it to understand that the explanations offered are an attempt to overwhelm the typical reader into believing that the 1031 is too intricate to be handled without their expensive services. Having direct experience with it myself, I know that the process is extremely simple. My disk includes documents that pertain only to a "forward" exchange. Only recently did the IRS provide a safe harbor for "reverse" exchanges. Although the reverse exchange is a bit more complex, it is also much more rarely used by the typical investor.
Although the QI is very much an escrow agent for proceeds and documents, it is different from the typical title company escrow services.
I have several more articles posted on The Creative Investor site for you to review (with more to follow). Take a look at IRC 1.1031(k)(1) through (g)(8) for the relevant regs on the process. If you have any further questions, please write again.
Thanks,
Larry Mayer
Hi Jennifer,
Please see my post to the author's original article. I would be happy to discuss any of these issues in detail with you, just call (866) 634-1031.
Best wishes.
Bill Exeter
Diversified Exchange Corporation
This article is very misleading as to all of the issues, responsibilities and risks involved and *****umed by/with the Qualified Intermediary and the services they provide.
For example, the author has left out of the "typical process" the fact that the Qualified Intermediary prepares all of the following documents: Like Kind Exchange Agreement, the Qualified Escrow or Trust Account Agreement; and the *****ignment, Acceptance and Conveyance Document and has to ensure the accuracy of the same - all included in the fee.
In addition, if the Qualified Intermediary is doing their job, they should be reviewing the preliminary title report, escrow instructions, purchase contract and estimated settlement instructions for any potential problems or issues that might affect the 1031 exchange. Although Qualified Intermediaries can not, do not, and should not provide legal, tax or financial advice, they should be doing all they can to protect their client by identifying problems and issues and making the client aware of them - all included in the same fee.
The Qualified Intermediary also walks the closing agent through the process to insure that all of the documentation is completed correctly. There are many real estate professionals and advisors that are not familiar with 1031 exchange transactions and/or all of the mechanical steps and documentation involved. And, clearly, some take risky short cuts in their discussions of same. The Qualified Intermediary is not just a repository for the documents, but should be acting as the client's quality control expert for their 1031 exchange transaction.
Furthermore, should the client's 1031 exchange transaction be disallowed by the service for any reason, the Qualified Intermediary is one of the first parties that will be named in any litigation. This is a huge risk that is *****umed by the Qualified Intermediary, and the Qualified Intermediary's risk of loss could be in the hundreds of thousands of dollars depending on the client's tax liability.
A financially stable Qualified Intermediary will always maintain sufficient levels of fidelity bond and errors and omissions insurance coverage to protect the client from these risks (we maintain $25 million in fidelity bond coverage). The costs to maintain the necessary insurance coverages is extremely expensive and the coverages are included in the same 1031 exchange fee.
The Qualified Intermediary should always offer and use a Qualified Escrow Account or Qualified Trust Account, again to protect the client from an unexpected bankruptcy filing by their Qualified Intermediary. We offer this at no additional charge to the taxpayer - its included in our 1031 exchange fee.
And, finally, most major Qualified Intermediaries' 1031 exchange fees for regular, forward 1031 exchange transactions are typically $750.00 to $1,000.00, not $2,000.00 to $20,000.00 as referenced. This nominal fee includes the "typical processes" referenced by the author, the issues clarified in my comments above AND the potential risks of litigation that the Qualified Intermediary will eventually face.
If the Qualified Intermediary provides superior service, it may appear that there is very little involved, but there is much more than meets the eye and the taxpayer should be aware of them.
William L. Exeter
President and Chief Operating Office
Diversified Exchange Corporation
http://www.diversifiedexchange.com
Note: Mr. Exeter has been in senior executive positions with Qualified Intermediary companies since 1986 and has administered in excess of 50,000 1031 exchange transactions. Mr. Exeter lectures extensively on 1031 exchange issues and is one of the founders of the industry trade group (Federation of Exchange Accommodators). You can reach Mr. Exeter at (866) 634-1031.