A frequent question arises in the context of structuring IRS Section 1031 Tax Deferred Exchanges. Just what is a Qualified Intermediary? That might be considered two questions in one. In other words, what is a Qualified Intermediary for purposes of the Tax Code and second, what makes an intermediary qualified to do business as such.

We will tackle the tax definitions first. It might be illuminating if we first discuss the function of the Qualified Intermediary in a Section 1031 tax deferred exchange. As one would expect, direct land swaps rarely occur since it is seldom that landowners will enjoy the combination of the elements of timing, desire, availability and price in the manner required for a successful exchange. Multi-party exchanges can resolve most of the issues, but timing will often prove extremely difficult to overcome. The Starker case and the subsequent regulations issued by the IRS that created safe harbors for deferred exchanges resulted in a need for a party, independent of the taxpayers’ control, to hold the funds pending resolution of the timing issues in such exchanges. The Regulations defining the safe harbors also set forth the requirements for serving as a Qualified Intermediary

The IRS regulations dealing with the requirements of a Qualified Intermediary are found at 26 CFR Section 1.1031(k)-1(f)(4)(iii)(A). Interestingly enough, the IRS has determined that the best way to define a Qualified Intermediary is any person that is not the taxpayer and that is not disqualified. That leaves us with a bit of a search of the code and regulations to determine who might be disqualified persons.

Section 1.1031(k)-1(k) outlines some of the disqualifications, provides some examples and points the way to the provisions of the code that define most of the remaining ones. It is not an exhaustive list. Section 1.1031(k)-1(k)(2) may be said to contain the primary limitation with the rest being a variation on the theme. This section disqualifies any person who is an agent of the taxpayer. The section provides a short list of examples disqualifying “a person who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties”.

The theme is one of control. The IRS is unwilling to consider the funds or property in the intermediary’s hands as being sufficiently insulated from the taxpayer’s control if they have a business or personal relationship that one would ordinarily infer that the intermediary would likely defer to the wishes of the taxpayer.

To that end, a party is disqualified to serve as an intermediary if they are a related party as defined in Code sections 267(b) or 707(b) with stricter limitations. The stricter limitations are that in the case of an intermediary the 50 percent control caps in those sections are reduced to ten percent each place they appear.

The following would be disqualified under the definitions of the relevant sections:

(a) Members of the taxpayer’s family, defined in subsection (c)(4) as; brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants; and

(b) An individual and a corporation more than 10 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;

(c) Two corporations which are members of the same controlled group defined as any -

Parent-subsidiary controlled group consisting of one or more chains of corporations connected through stock ownership with a common parent corporation if –

(1)stock possessing at more than 10 percent of the total combined voting power of all classes of stock entitled to vote or at least 10 percent of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is owned (within the meaning of subsection (d)(1)) by one or more of the other corporations; and

(2) the common parent corporation owns (within the meaning of subsection (d)(1)) stock possessing at more than 10 percent of the total combined voting power of all classes of stock entitled to vote or at more than 10 percent of the total value of shares of all classes of stock of at least one of the other corporations, excluding, in computing such voting power or value, stock owned directly by such other corporations.

Brother-sister controlled group consisting of two or more corporations if 5 or fewer persons who are individuals, estates, or trusts own (within the meaning of subsection (d)(2)) stock possessing –

(1) more than 10 percent of the total combined voting power of all classes of stock entitled to vote or at more than 10 percent of the total value of shares of all classes of the stock of each corporation, and

(2) more than 10 percent of the total combined voting power of all classes of stock entitled to vote or more than 10 percent of the total value of shares of all classes of stock of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation.

Combined group consisting of three or more corporations each of which is a member of a group of corporations described above, and one of which –

(1) is a common parent corporation included in a Parent-subsidiary controlled group, and also

(2) is included in a brother-sister controlled group.

(d) A grantor and a fiduciary of any trust;

(e) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;

(f) A fiduciary of a trust and a beneficiary of such trust;

(g) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

(h) A fiduciary of a trust and a corporation more than 10 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

(i) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

(j) A corporation and a partnership if the same persons own –

(1) more than 10 percent in value of the outstanding stock of the corporation, and

(2) more than 10 percent of the capital interest, or the profits interest, in the partnership;

(k) An S corporation and another S corporation if the same persons own more than 10 percent in value of the outstanding stock of each corporation;

(l) An S corporation and a C corporation, if the same persons own more than 10 percent in value of the outstanding stock of each corporation; or

(m) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.

(n) a partnership and a person owning, directly or indirectly, more than 10 percent of the capital interest, or the profits interest, in such partnership; or

(o) two partnerships in which the same persons own, directly or indirectly, more than 10 percent of the capital interests or profits interests;

(p) if the intermediary bears one of the above relationships to a person who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties.

There are exceptions to disqualification for a provider of services for the taxpayer with respect to exchanges intended to qualify under section 1031; and for routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company.

An example of how these rules might apply may prove helpful. C is a corporation that is only engaged in the trade or business of acting as an intermediary to facilitate deferred exchanges. Each of 5 individuals owns 20 percent of the outstanding stock of C. S, one of the individuals that owns 20 percent of C is married to R who owns Realty Company that served as Taxpayer’s agent in a transaction that occurred 18 months previously. C is a disqualified person because Realty Company is a related party to R who, in turn, is a related party to S who directly or indirectly, owns more than 10 percent of the stock of C.

Section 1031(f) sets forth special rules permitting limited exchanges between related persons and includes the following language: “This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.” The clear lesson from that provision is that a transaction artificially structured for no purpose other than to avoid related party issues will be disregarded by the IRS.

Relevant provisions of the applicable regulations are included at the end of this article for reference purposes. Before we conclude we will discuss the second question alluded to previously. Just what does qualify an intermediary to do business competently in the highly complex area of tax deferred exchanges. All Qualified Intermediaries are not equally competent and, at present there is little in the way of regulatory supervision of the industry. Some companies or individuals may market themselves as Qualified Intermediaries but have the ability to do little more than simply hold money in a bank account. A truly qualified exchange company does much, much more.

Before beginning a 1031 exchange, seeking answers to the following questions should prove helpful in selecting a Qualified Intermediary:

- Does the Qualified Intermediary carry a Security Bond and Errors & Omissions insurance to protect their transactions?

- Does the Qualified Intermediary have full-time employees who are trained and experienced in exchanges?

- Does the Qualified Intermediary maintain rigorous training and continuing professional education for its staff to maintain and continually improve proficiency?

- Is the QI a member of the Federation of Exchange Accommodators, a professional

Trade organization that oversees and educates professional intermediaries?

- Is the Qualified Intermediary charging a reasonable fee for the work it’s doing and the services provided?

A good Qualified Intermediary should demonstrate sound business practices. These would include setting up a separate entity (or EAT) for each client’s property in reverse exchanges so that properties of different taxpayers are not commingled and to avoid liability resulting from previous transactions. Sound business practices should include requiring taxpayers to obtain hazard insurance on the parked property that identifies the EAT as an additional insured; requiring an indemnification for environmental hazards or require an environmental assessment; requiring non-recourse financing only as to the EAT. The Exchange Accommodation Titleholder in reverse exchanges should be a bankruptcy-remote entity, so that the taxpayer’s property will not become part of a bankruptcy estate.

Most importantly, the Qualified Intermediary must have employees that are well trained and experienced in all forms of tax deferred exchanges. This is particularly crucial in reverse and build-to-suit exchanges, so that all customers will be fully assured their exchange is being structured properly. Staffing should be full-time and more than adequate so that someone will be readily available to answer questions and assist in structuring transactions.

1031 Regulations Sec. 1.1031(k)-1(k)

(k) Definition of disqualified person.

(1) For purposes of this section, a disqualified person is a person described in paragraph (k)(2), (k)(3), or (k)(4) of this section.

(2) The person is the agent of the taxpayer at the time of the transaction. For this purpose, a person who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer at the time of the transaction. Solely for purposes of this paragraph (k)(2), performance of the following services will not be taken into account;

(i) Services for the taxpayer with respect to exchanges of property intended to qualify for non-recognition of gain or loss under section 1031; and

(ii) Routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company.

(3) The person and the taxpayer bear a relationship described in either section 267(b) or section 707(b) (determined by substituting in each section “10 percent” for “50 percent” each place it appears).

(4)(i) Except as provided in paragraph (k)(4)(ii) of this section, the person and a person described in paragraph (k)(2) of this section bear a relationship described in either section 267(b) or 707(b) (determined by substituting in each section “10 percent” for “50 percent” each place it appears).

(ii) In the case of a transfer of relinquished property made by a taxpayer on or after January 17, 2001, paragraph (k)(4)(i) of this section does not apply to a bank (as defined in section 581) or a bank affiliate if, but for this paragraph (k)(4)(ii), the bank or bank affiliate would be a disqualified person under paragraph (k)(4)(i) of this section solely because it is a member of the same controlled group (as determined under section 267(f)(1), substituting “10 percent” for “50 percent” where it appears) as a person that has provided investment banking or brokerage services to the taxpayer within the 2-year period described in paragraph (k)(2) of this section. For purposes of this paragraph (k)(4)(ii), a bank affiliate is a corporation whose principal activity is rendering services to facilitate exchanges of property intended to qualify for non-recognition of gain under section 1031 and all of whose stock is owned by either a bank or a bank holding company (within the meaning of section 2(a) of the Bank Holding Company Act of 1956 (12 U.S.C. 1841(a)).

(5) (Examples deleted due to space considerations.)

Section 267(a) In general

(1) Deduction for losses disallowed
No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

Section 267(b)Relationships
The persons referred to in subsection (a) are:

(1) Members of a family, as defined in subsection (c)(4);

(2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;

(3) Two corporations which are members of the same controlled group (as defined in subsection (f));

(4) A grantor and a fiduciary of any trust;

(5) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;

(6) A fiduciary of a trust and a beneficiary of such trust;

(7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

(8) A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

(9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

(10) A corporation and a partnership if the same persons own -

(A) more than 50 percent in value of the outstanding stock of the corporation, and

(B) more than 50 percent of the capital interest, or the profits interest, in the partnership;

(11) An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation;

(12) An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or

(13) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.

Section 707(b) Certain sales or exchanges of property with respect to
controlled partnerships

(1) Losses disallowed
No deduction shall be allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between -

(A) a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or

(B) two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests. In the case of a subsequent sale or exchange by a transferee described in this paragraph, section 267(d) shall be applicable as if the loss were disallowed under section 267(a)(1). For purposes of section 267(a)(2), partnerships described in subparagraph (B) of this paragraph shall be treated as persons specified in section 267(b).