Most real estate investors are familiar with 1031 Exchange, also called a like-kind exchange. Many people assume that if they do a 1031 Exchange on their property, there is no obligation to pay any tax until the new asset appreciates or is sold for profit.

It’s more complicated than this. The 1031 exchange intermediary is the person who holds the money and property that you do not immediately reinvest into a like-kind investment. There are legal requirements for this part of your 1031 Exchange, too.

An opportunity to defer capital gains tax

1031 Exchanges are an opportunity to defer paying capital gains tax on investment real estate. When you reinvest the proceeds of a 1031 Exchange into another investment property, you are buying “boot.”

The boot is anything that was not part of the original investment. It includes money, debt relief, replacement property that is not like-kind to your initial property, or other expenses associated with the exchange process.

Typically, when you do a 1031 Exchange, you will need to work with someone in the “intermediary” space because your title company or the closing attorney is neither set up nor permitted to be involved in any way.

1031 Intermediary requirements

The intermediary has specific legal requirements that they are held accountable to. While their primary job is to keep the money and property that were part of your 1031 Exchange, they have more going on under the surface.

They are tasked with ensuring that you follow specific rules for reinvesting or “exchanging” your 1031 Exchange funds. These rules dictate how much you must use to purchase your replacement property and what you can and cannot do with the funds.

The intermediary is also responsible for reporting to the IRS on your behalf. If you reinvest or exchange more than $5000 of those 1031 Exchange funds without meeting those requirements, it’s considered a taxable event by the IRS. It means that you could end up paying capital gains tax on that additional money.

So, who is the intermediary?

An intermediary works for you. The person or firm you work with should be familiar with 1031 Exchanges and its laws, as well as how to set up a qualified intermediary agreement.

The Qualified Intermediary Agreement holds your funds in escrow and makes sure that they follow specific 1031 IRS rules. You can think of it as a set of guidelines for how the process should be handled, and it helps to make sure everyone is on the same page.

An intermediary is typically a large (and experienced) financial institution specializing in this type of transaction and has completed many before! They must be familiar with the 1031 Exchange laws and how they impact your transaction.

Your intermediary will request a “qualified intermediary agreement,” or QIA for short, which is a contract that holds the property as yours until you sell it, as well as identifies them as an agent of the IRS. It helps to ensure that everyone involved in your 1031 Exchange process is on the same page regarding what they are allowed to do.

Conclusion

An intermediary is a person or firm that holds the property you exchange in escrow until it’s sold. If your intermediary fails to follow IRS guidelines, it could result in a taxable event for you.