A 1031 exchange lets investors sell one investment property and defer their taxes by using the proceeds to buy another property. Of course, this is a simplified explanation—many 1031 exchanges are more complex than a simple one-for-one property swap.
Whatever the nature of the transaction, a 1031 exchange is a rather complicated process and IRS tax law says you cannot simply complete an exchange by yourself. To be IRS-compliant, you’ll need to use a third party to set up the exchange for you.
This third party is known as an exchange facilitator. According to the IRS, your exchange facilitator can be:
- a qualified intermediary (more on those in the next section), or
- a “transferee, escrow holder, trustee, or other person that holds exchange funds for you in a deferred exchange under the terms of an escrow agreement, trust agreement, or exchange agreement.”
A qualified intermediary (QI) is what you need
While the IRS has a list of possible entities that could facilitate a 1031 exchange, a qualified intermediary (QI) is generally the best way to go. This is a person or company that facilitates the completion of 1031 exchanges. The QI:
- acquires the original property from the owner,
- transfers the property to the buyer,
- holds the sale proceeds in escrow,
- acquires the replacement property from the seller,
- transfers the replacement property to the borrower, and
- ensures all exchange steps and documentation occur in a timely manner.
The IRS has rules about who a QI cannot be. A qualified intermediary cannot be your real estate agent, someone related to you, or a person who is related to your real estate agent. Anyone who meets one of these criteria is a "disqualified person."
In simple terms, a QI must be a neutral third party who doesn’t have a major conflict of interest in the transaction.
How much does a qualified intermediary cost?
As you might expect, qualified intermediaries aren’t free. For a typical 1031 exchange, where you’re selling one property and acquiring a replacement property later on, you should expect to pay anywhere between $600 and $1,200 to a qualified intermediary who facilitates the exchange.
In addition, the qualified intermediary is generally entitled to keep the interest your money earns while they hold it in escrow. For example, if the sale of your property results in net proceeds of $250,000, the qualified intermediary holds this money in an interest-bearing account until the purchase of the replacement property is complete. This can be several thousand dollars of interest in many cases. This is typically how the qualified intermediary makes the bulk of their money.
If it helps you avoid a massive tax bill upon the sale of your investment property, paying a qualified intermediary can be well worth the cost. Just be aware that you’ll need to account for this expense.
How to choose a qualified intermediary
The qualified intermediary industry isn't heavily regulated at the federal level and is only formally regulated in a few states. So it’s very important to do your homework before choosing a QI for your 1031 exchange. Check reviews and choose a reputable QI who has completed many successful transactions. A great QI can make the complicated process of a 1031 exchange seem much less complex.
Finally, it’s important to point out that a QI is not a tax advisor. You still need a CPA or another tax professional to ensure that your 1031 exchange is IRS-compliant. Many tax advisors have qualified intermediaries that they trust and have worked with in the past, so your tax professional is a great place to start your QI search.