One of the basic requirements of a 1031 exchange is that the proceeds from the sale of the old property cannot be touched by the Seller. These proceeds must be held by an independent third party the IRS calls a qualified intermediary. Who is qualified to be an intermediary? How do they get paid? What do you watch out for when you hire an intermediary? These are all questions that every person doing an exchange should ask.

The IRS does not define qualified intermediary. Instead, they identify who cannot be an intermediary (the "disqualified"). The "disqualified" include pretty much anyone close to the Sellers: their intermediary cannot be their attorney, their CPA, anyone related to them, anyone in business with them or anyone who works for them. They really must be an independent third party.

There are no education, registration or certification requirements for intermediaries by any of the states or the federal government. I used to joke that a convicted felon could be an intermediary as long as they were not part of the disqualified list. This isn't funny anymore because a major business journal recently reported that an intermediary (who is still practicing) had once been convicted of several felonies. Be careful who you deal with. No one is going to protect you from a bad or fraudulent intermediary.

Section 1031 is a form-driven code section, meaning that sellers must carefully dot the i's and cross the t's. Any tiny infraction of the rules can, and will, get an exchange disallowed. It is an intermediary's job to make sure that everything is done correctly, yet there are no minimum entry-level requirements for qualified intermediaries. Imagine there were no entry-level requirements to be a real estate agent. Imagine people making a choice of an uneducated and inexperienced agent to negotiate their transactions based solely on their low fee.

Intermediaries get compensated in one (or both) of two ways: the fees they charge to handle the transaction and a portion of the interest earned while they hold the funds. Some intermediaries, including our firm, charge a single fee for the entire transaction. In most of the country this fee typically runs about $750 for the entire transaction. Some intermediaries charge a separate fee for each piece: they may charge $400 to handle the sale of the old property and another $400 to handle the purchase of the new property. And it is not uncommon for intermediaries to charge a set-up fee of perhaps $150 to handle the exchange account. If you ask this intermediary the charge for handling the sale of your property, you would probably be quoted $400. However, the real cost of doing an exchange with this intermediary could run as much as $950. So, make sure you understand all of the exchange costs.

Most intermediaries put exchange proceeds into a commingled account with monies from other exchanges. A recent court case ruled that commingled intermediary funds are available to any creditor of the intermediary. The court stipulated that only funds held in a separate account for specific transactions are protected from creditors.

Commingled accounts can get a higher rate of return and intermediaries prefer them because they keep all or most of the interest. Commingled accounts also are a tempting target for abuse. Clients of several intermediaries found this out last year when their monies disappeared, either because of theft, or because the intermediary was day trading with them. Make sure that your money is put in a separate account just for you and that you are getting all the interest earned.

In summary, chose a qualified intermediary who is ethical and well grounded in tax and real estate law, upfront about charges, and willing to put your money in a separate account just for you and give you all the interest the account earns.