Inexperienced Qualified Intermediary Kills Taxpayer’s 1031 Exchange

Failed Exchange Costly to Taxpayer and QI

A recent case highlights the importance of using caution when choosing a Qualified Intermediary (QI) to facilitate your 1031 tax-deferred exchange. This case was not a tax case but a case that involved the Taxpayer seeking damages from the QI. In Kreisers, Inc., et al. v. QI Title Limited Partnership d/b/a QI Title and d/b/a The Title Resource Network (SD 2nd Cir.), a title company also provided qualified intermediary services. 

Kreisers was an s-corp that wanted to structure an improvement exchange that would allow them to use 1031 exchange funds to make improvements to the replacement property before they took title from the Seller. An improvement exchange is a commonly used exchange strategy but it does take quite a bit of planning to structure properly. The improvements must be completed before title of the replacement property is conveyed to the exchanger so the QI or Exchange Accommodation Titleholder (EAT) usually acquires the replacement property directly from the Seller and makes the improvements before conveying the improved property to the Exchanger before the end of the 180-Day Exchange Period. 

There were a number of mistakes made by the QI in this case including the QI (hopefully just inadvertently) committing tax fraud. A brief summary follows:

    • The QI failed to review the transaction with the Exchanger before preparing the documents.
    • Although the QI advertised that they could facilitate improvement exchanges, they really did not do them.
    • Although there was enough time, the QI sent the exchange documents for signature at closing rather than sending directly to the Exchanger or their advisors to review. 
    • The QI had the Exchanger sign a blank 45-Day Identification letter. The QI told the Exchanger they would complete the property identification information at a later date. The QI did eventually fill in the replacement property description but did not list any improvements. A copy was not provided to Exchanger for review
      or their records.
    • The replacement property was acquired by the Exchanger a few days after the relinquished property closed and again no paperwork was provided in advance of closing for review. (Once title is deeded to the Exchanger, there is no way to use exchange funds to constructimprovements.)
    • After acquiring the replacement property, the Exchanger still had $328,000 in their exchange account and QI never discussed the Exchanger’s intent with those funds. 
    • The $328,000 was paid to the Exchanger after the 45-Day Identification Period expired.

This Exchanger relied on the QI to guide them through the 1031 exchange process and trusted all was proceeding as it should. The Exchanger had to recognize $328,000 of gain resulting in a $172,804 tax liability.

The judge ruled the QI held itself out to be an expert and had a legal duty to provide professional services comparable to that of other QIs. The QI failed to discuss the transaction in detail with the Exchanger and therefore did not structure the transaction properly.

The QI argued that it had no liability because the exchange documents included indemnification language and advised the Exchanger to consult their own tax and/or legal advisors but the judge ruled the QI was negligent and liable for damages.  

Lessons Learned

This case provides many lessons for Exchangers and QIs alike, especially those considering the possibility of offering QI services. When the real estate industry is doing well then 1031 exchange activity often picks up and for many allied professions, 1031 is often eyed as another possible revenue stream even though they are not experts on section 1031. However, Section 1031 is a very complicated section of the tax code and failure to comply can easily create a tax liability for Exchangers. Qualified Intermediaries provide a very specialized service and it is easy to miss something. 

The 1031 CORP. Advantage

In our 25+ years of acting as a QI, 1031 CORP. has worked hard to develop written Standard Operating Procedures to ensure tax regulations as well as company policies are always followed. 

    • Most of the 1031 CORP. Exchange Team has earned the Certified Exchange Specialist® (CES®) designation which means his/her knowledge of Section 1031 and its facilitation has been verified through independent third-party testing and he/she is required to complete twenty hours of continuing education every two years.
    • Each exchange is reviewed with the Exchanger or his/her tax and/or legal advisors before we initiate a transaction. We also review the steps of an exchange and the requirements of a successful exchange.
    • Unlike many other QIs who prefer to send their exchange documents to the closing officer to have signed by the Exchanger, 1031 CORP. sends the documents directly to the Exchanger or their advisor so they can review and execute prior to closing.
    • Regardless of the day of the week or time of day, our Exchange Team reviews each 45-Day Identification letter as it comes in to ensure it is completed property and calls any potential concerns to the Exchanger immediately (yes, even if you are sending it over at 11:50 pm!).  And of course, we will not fill in your property descriptions if you send in a signed, blank letter. This is tax fraud! 
    • Unlike many other QIs who no longer provide a fidelity bond, 1031 CORP. maintains a multi-million dollar policy that is designed specifically to protect our Exchangers not 1031 CORP. Many off the shelf policies protect the QI not the Exchangers.
    • We walk our Exchangers though each step of the exchange transaction to make sure they understand it and it is completed properly.
    • 1031 CORP. is a member of the Federation of Exchange Accommodators (FEA) which keeps us current on tax changes that require tweaks in our procedures or documents. 
    • 1031 CORP. stays current on the various QI laws and how to stay in compliance.
    • 1031 CORP. stays current on the various non-resident state wthholding requirements.
    • 1031 CORP. exchange funds are held in segregated, interest bearing deposit accounts set up for the benefit of our Exchangers. The accounts are FDIC insured and our Exchangers can view their account balance on-line any time through the bank’s website. A Qualified Escrow Agreement (QEA) is always available and requires you to provide the bank with your written authorization before the bank can process any request from 1031 CORP.

In closing, when choosing a QI for yourself or your client, it is essential to assess their experience, their reputation and the security of funds. A good Qualified Intermediary will make the exchange process an easy and worry-free transaction for the Exchanger and his/her advisors.