When a Qualified Intermediary Fails: Protecting a 1031 Exchange and Reporting the Loss

In a deferred exchange, you sell your relinquished property and the sale proceeds go to a qualified intermediary, not to you. The intermediary holds the money for weeks or months, then buys the replacement property and transfers it to you. That arrangement is what keeps you out of constructive receipt of the cash.

It also means a company you may have found through a title agent or a quick search is holding a large sum of your money with little regulation. When an intermediary fails, through bankruptcy, fraud, or simple mismanagement, the investor faces two losses: the money and the tax deferral. Here is what the rules provide and how to reduce the risk.

What a qualified intermediary is

Treas. Reg. 1.1031(k)-1(g)(4) creates the qualified intermediary safe harbor. A qualified intermediary is a person who is not you or a disqualified person, who enters into a written exchange agreement with you, and who, as required by that agreement, acquires the relinquished property from you, transfers it, acquires the replacement property, and transfers it to you. Under the regulation, the intermediary is treated as acquiring and transferring property if it acquires and transfers legal title, or if it enters into the relevant purchase and sale agreements and those rights are assigned to it with notice to the other parties.

When the safe harbor applies, the intermediary is not treated as your agent, so its possession of the money is not your receipt of the money.

Who cannot serve

Treas. Reg. 1.1031(k)-1(k) defines disqualified persons. They include your agent at the time of the transaction, and anyone who acted as your employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two years ending on the transfer of the first relinquished property. Services relating to exchanges themselves, and routine financial, title insurance, escrow, or trust services by a financial institution, title insurer, or escrow company, are disregarded. Related persons under modified 267(b) and 707(b) tests, using 10 percent instead of 50 percent, are also disqualified.

So your longtime CPA or the attorney who handled your last closing generally cannot be your intermediary. Using one breaks the safe harbor.

The limits on your access to the money

Treas. Reg. 1.1031(k)-1(g)(6) requires the exchange agreement to expressly limit your right to receive, pledge, borrow, or otherwise obtain the benefits of the money before the end of the exchange period. The permitted exceptions are narrow: if you identify nothing by the end of the 45-day identification period, you may get the funds after that period ends; and if you identified property, you may get the funds after receiving all replacement property to which you are entitled, or upon a material and substantial contingency after the identification period that is in writing and beyond your control.

These limits protect your deferral. They also mean you cannot pull your money out at the first sign of trouble with the intermediary without potentially triggering tax on all of it.

If the intermediary fails

The installment rule in the regulations

Treas. Reg. 1.1031(k)-1(j)(2) already helps when an exchange fails for any reason. If you used a qualified intermediary and had a bona fide intent at the start of the exchange period to complete an exchange, the determination of whether you received a payment for installment sale purposes is made as if the intermediary were not your agent. The regulation specifically says a person who otherwise meets the qualified intermediary definition is treated as one even though it ultimately fails to acquire and transfer replacement property. That lets gain be reported when cash is actually received, rather than when the relinquished property was sold. The general rules for failed exchanges are in the deadline guide.

Rev. Proc. 2010-14: the safe harbor for QI defaults

After several intermediary collapses, the IRS issued Rev. Proc. 2010-14. It provides a safe harbor method for reporting gain when a taxpayer could not complete an exchange because the qualified intermediary defaulted on its obligation to acquire and transfer replacement property, in connection with a bankruptcy or receivership of the intermediary.

Under the safe harbor, gain is reported as payments are actually received, for example as distributions come from the bankruptcy trustee or receiver, using a safe harbor gross profit ratio. Debt relief that would otherwise be treated as a payment in the year of the transfer is limited. Conditions include that you transferred the relinquished property to the intermediary, properly identified replacement property unless the default occurred before the identification deadline, did not complete the exchange solely because of the default, and did not have actual or constructive receipt of the proceeds before the bankruptcy or receivership.

Read the full revenue procedure before relying on it. Its conditions and computations are specific, and the facts of intermediary failures vary.

The loss itself

If part of your money is never recovered, the unrecovered amount may produce a loss. Its character and timing depend on the facts, including whether it is treated as a loss on the sale, a theft loss, or a bad debt, and when there is no reasonable prospect of recovery. Those questions often stay open while a bankruptcy proceeds.

Choosing an intermediary

The tax rules soften a failure. They do not prevent one. Questions worth asking before you sign:

• How are exchange funds held? Segregated accounts in your name or for your benefit, or commingled with other clients' money?
• Who can move the money, and does withdrawal require your signature?
• What fidelity bond and errors and omissions coverage does the intermediary carry, and in what amounts?
• Is it affiliated with a bank or title company with its own capital and oversight?
• Will it agree to a qualified escrow account or qualified trust under Treas. Reg. 1.1031(k)-1(g)(3) for the funds?
• How long has it operated, and can it provide references?

If the replacement property is coming from a family member or an entity you control, the intermediary does not shield you from the related-party rules; see the related-party guide.

An intermediary offering to pay you unusually high interest on exchange funds is investing them somewhere. That should prompt questions, not excitement.

Reporting

A completed exchange is reported on Form 8824. A failed exchange is generally reported as a sale on Form 4797, with Form 6252 for installment reporting where available. Under Rev. Proc. 2010-14, the safe harbor reporting follows the procedure's own rules. Leftover funds the intermediary returns after a partial exchange are boot; see the boot guide.

Your intermediary is holding your tax deferral in its bank account. Pick it like that matters, because it does.