Choosing a qualified intermediary

What a qualified intermediary actually does

The mechanics are narrow, and worth understanding precisely, because the value is legal rather than advisory.

1. Before your sale closes, you sign an exchange agreement assigning your rights in the purchase contract to the intermediary.
2. At closing, escrow wires the net proceeds to the intermediary rather than to you. The deed still goes directly from you to your buyer.
3. The intermediary holds the funds and provides written notice of your day 45 and day 180 deadlines.
4. You deliver your written identification to them by day 45.
5. When your replacement property closes, they wire the funds directly to that closing.
6. Any leftover funds are returned to you after the exchange period ends, and are taxable as boot.

Notice what is not on that list. A qualified intermediary does not give tax advice, does not pick your replacement property, does not tell you whether an exchange is a good idea, and generally does not warn you if your identification is unwise. They are a compliance and custody function. The advisory work sits elsewhere, which is why the intermediary, the CPA, and the advisor are three different roles.

Who cannot be your intermediary

Treasury Regulation 1.1031(k)-1(k) defines a "disqualified person," and using one voids the safe harbor. The rule is broader than people expect.

The regulation gap

Here is the part that surprises most people, and it deserves to be stated flatly.

There is no federal license to be a qualified intermediary. No registration, no minimum capital, no examination, no federal oversight body. The Treasury regulations define who is disqualified from the role, but they impose no requirements on who is qualified for it. Anyone can form a company tomorrow and begin holding seven-figure sums of other people's money.

A minority of states have filled some of the gap. California's law, effective January 1, 2009, is among the more substantive. It requires an exchange facilitator to maintain a fidelity bond of at least $1 million or an equivalent deposit of cash, securities, or a letter of credit, plus errors and omissions coverage of at least $250,000 or an equivalent deposit, and to invest exchange funds under the prudent investor standard. It also requires notifying clients within ten days of a change in company ownership, and it prohibits misrepresentation and failure to account for funds.

Nevada, Colorado, Idaho, Maine, Oregon, Virginia, and Washington have adopted requirements of varying strength. Most states have adopted nothing at all.

The practical conclusion: state law will not choose an intermediary for you. Even in California, meeting the statutory minimum is a floor, not a recommendation.

When intermediaries have failed

This is not a theoretical risk. The industry has a history, concentrated around 2007 and 2008, and it is the reason experienced advisors are particular about this choice.

• A Nevada-based facilitator collapsed in 2007 after its principal misappropriated roughly $95 million of client exchange funds to buy unrelated businesses.
• An operator of a group of exchange companies was convicted in a scheme involving approximately $132 million of client money used for personal purchases and other ventures.
• In December 2008, a large title-affiliated facilitator froze roughly $450 million of client exchange funds after investing them in auction rate securities that stopped trading. Clients lost use of their money, missed their deadlines, and many ended up with taxable sales and litigation instead of exchanges.

That last case is the most instructive, because there was no fraud in the ordinary sense. It was a large, established, reputable-looking firm that invested client funds in something that seemed safe and turned out to be illiquid at exactly the wrong moment. Size and name recognition did not protect anyone. How the money was held did.

How your funds should be held

Ask specifically about the structure. The differences are not cosmetic.

Also ask about insurance in concrete terms. A fidelity bond covers theft or dishonesty by employees. Errors and omissions coverage covers professional mistakes. They are different policies covering different failures, and a QI should carry both. Ask for the amounts, and consider whether they are large relative to your exchange, not just large in the abstract. A $1 million bond is meaningful protection on a $600,000 exchange and much less so on a $9 million one.

Eleven questions to ask

A good intermediary answers all eleven without hesitation, usually because they are asked constantly. Hesitation on questions 2, 4, 7, or 9 is meaningful information.

Red flags

• Vagueness about where the money sits. If you cannot get a clear answer about segregation and the bank, stop.
• A fee that is far below the market. Unusually cheap often means the firm is monetizing your float instead, and it can signal thin capitalization.
• Pressure to use a particular replacement property. An intermediary who also sells you the replacement, or is paid by whoever does, has a conflict they should be disclosing prominently.
• A referral you have not vetted. Your agent's recommendation may be excellent, or may reflect a referral arrangement. Ask directly whether anyone is compensated for the referral.
• No bond, or no errors and omissions coverage. Not negotiable.
• Recent change of ownership they did not mention. In California they are required to tell you within ten days. Elsewhere they simply should.
• Reluctance to provide professional references. Established firms have CPAs and attorneys who will vouch for them.

Fees, and the interest question

A standard delayed exchange generally runs about $1,000 to $1,500, with a few hundred dollars added for each replacement property beyond the first. Reverse and improvement exchanges cost substantially more, often $3,500 to $7,500 or higher, because a separate holding entity has to be formed, capitalized, insured, and administered.

The line item people miss is interest. Your proceeds may sit with the intermediary for up to six months. On $800,000, that interest is not trivial. Practice varies: some QIs keep all of it, some split it, some credit it to you above a threshold, and some charge a lower headline fee precisely because they are keeping the float.

None of these arrangements is improper. What matters is that you know which one you are agreeing to. Ask, and get the answer in the engagement letter.

Set against a tax bill that commonly runs into six figures, the fee itself should not drive the decision. Choose on custody practices and track record, then compare price among the firms that pass.

When to engage one

As soon as you have an accepted offer. Not the week of closing, and certainly not the day of.

Setup usually takes one to two business days, so it is tempting to leave it late. Two reasons not to. First, the exchange cooperation language belongs in the purchase agreement, which means before signing is better than after. Second, if the intermediary you want is unavailable or something in the vetting gives you pause, you want the time to choose differently.

And the absolute limit is unforgiving: if escrow funds to you before an intermediary is in place, the exchange is legally impossible. That is the one failure in this entire process with no remedy at all.