The Give and Take of QIs - Taxes
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SECTION: Taxes

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Contact Kim Phelan at (800) 388-0650 ext. 340.


The Give and Take of QIs

Written By Mary Sedor, with contributions by Kim Phelan

Article Date: 09-01-2007
Copyright (C) 2007 Associated Equipment Distributors. All Rights Reserved.


The alleged misconduct of two qualified intermediary groups shouldn't prevent dealers from considering like-kind exchange as an important tax deferral tool.

The methods applied in the like-kind exchange (LKE) industry have been the subject of some scrutiny over the last few months following allegations that two separate qualified intermediary (QI) groups mishandled funds.  

Both incidents involved real estate exchanges, but lessons from investor losses are certainly relevant to construction equipment distributors who utilize the Internal Revenue Code 1031 provision for deferring gain or income taxes on certain types of property transactions. Awareness of how like-kind exchange works, as well as the role played by the QI, is vital, sources say, to the successful implementation of LKE transactions.

The first case, according to a Wall Street Journal article, involves Southwest Exchange based in Henderson, Nev., and Qualified Exchange Services in Santa Barbara, Calif, both owned by businessman Donald McGhan. His companies allegedly “misappropriated more than $95 million of more than 130 customers’ proceeds to fund other business and personal activities,” according to the report. Several investors have filed suit against McGhan, and the case is now in federal court in Los Angeles. 

In the second case, 1031 Tax Group, owned by Edward Okun, reportedly owes more than 300 investors an estimated $151 million after allegedly “[borrowing] money…to fund real estate investments made by Investment Properties of America, another company controlled by Okun,” according to the Wall Street Journal. 1031 Tax Group filed for bankruptcy in May. 

The Federation of Exchange Accommodators (FEA), the association representing professional QIs, responded by reviewing the cases and suspending the memberships of both the 1031 Tax Group and Southwest Exchange due to “credible allegations that transactions had not been funded in a timely manner,” according to a statement. 

“As Qualified Intermediaries, we have an obligation to ensure that our firms have liquid funds to meet the obligations to our customers,” writes the FEA. 

Like Kind Exchange Explained
Essentially, like-kind exchange enables taxpayers to defer taxes on recognized gain (of up to 40 percent of sales proceeds) on the sale of depreciated business assets, including rental assets, on the condition that the taxpayer exchanges the business or investment property for “like-kind” business or investment property. The property must be used for investment/trade or business purposes and cannot be considered inventory. 


Also, like-kind exchange is tax-deferred not tax-free. Ultimately, when a 1031-participating business recognizes gain on the sale of its assets, taxes must be paid on the then-current gain amount.

The Internal Revenue Code 1031 was initiated in 1921, but the construction equipment industry began broadly adopting like-kind exchanges in the last seven to 10 years, according to Brent Abrahm, president and CEO of Accruit, AED’s Preferred Provider of like-kind exchange services. His company is a personal property QI that has managed more than $6 billion in heavy equipment asset sales in the past 12 months, handling both program and single exchanges. Accruit is also the exclusive provider of like-kind exchange services for AED member Ritchie Bros. Auctioneers, providing single exchange services to their consignors.

The increased use of LKEs in this industry has been fueled, says Abrahm, by bonus depreciation, dedicated rental fleets, and by the IRS itself – clarifying regulations to the 1031 Code from the Treasury Department have made LKEs more accessible to more taxpayers.

The Role of Qualified Intermediaries
According to the FEA Web site, safe harbor regulations require taxpayers to use a QI as a facilitator of the tax-deferred exchange. The sale proceeds go directly to the QI, who holds them until they are used to acquire replacement property. The QI then pays for the replacement property on the taxpayer’s behalf, and the taxpayer takes possession of the replacement asset.


In performing a safe harbor exchange, it is the role of the QI to safeguard the taxpayer’s funds while simultaneously ensuring that the taxpayer does not have actual or constructive receipt of the funds during the exchange. The IRS prohibits the taxpayer from receiving, pledging, borrowing or otherwise obtaining any kind of benefit on the proceeds, including any interest earned during the time funds are in the account, according to Julianna Clementi-Ryan, vice president of Nationwide Exchange Services, an independent qualified intermediary company. 

QIs must be able to produce client funds within 24 hours, so the investment should be highly liquid and conservative, according to Mary Foster, president of 1031 Services and the incoming 2008 president of the FEA. 1031 Services, based in Bellevue, Wash., is an independent qualified intermediary. Like-kind exchange regulations allow the taxpayer to use funds for replacement property within the first 45 days after the sale date or to identify a new purchase that will occur within the entire 180-day lifespan of an exchange. 

And if funds are unavailable to acquire the taxpayer’s replacement property due to a QI’s poor investment choices or fraudulent activities, trouble is sure to follow.

“That should never, ever happen,” said tax advisor Steve Pierson, shareholder, Seldon Fox Ltd., an audit and tax services firm. He says the chief attribute a dealer should look for in a QI is a stellar record and unblemished reputation.

Broadly speaking, the No. 1 responsibility of a QI is to follow IRS regulations – which include the written agreement into which the taxpayer enters with the QI (in some cases the parties sign a “master exchange agreement” that covers a high volume of transactions), according to Pierson. Part of the agreement calls for notification of all involved parties, he adds. Overlooking this important communication step can be an LKE deal-breaker.

Equally important for dealer executives to understand about the QI’s function in the LKE process is what a QI cannot be. 

“A qualified intermediary cannot be an agent of the taxpayer who’s doing the exchange,” Pierson said. “An agent would be defined as an employee of that taxpayer, an attorney, an accountant, real estate broker (in those types of exchanges) or the investment banker broker. [QIs] cannot be advisors. They know the rules and they do help the taxpayer to comply with those rules. But they’re not supposed to give advice beyond that.” 

For that reason, Pierson strongly suggests that equipment dealers who are considering LKE and are shopping for a QI ought to first seek out a knowledgeable, independent advisor – such as an LKE-savvy attorney or   accountant – to guide them through the many decisions in the process.

What’s Mine is Yours, Temporarily
Currently states do not govern how QIs handle client funds, with the exception of Nevada, according to Foster. Beyond rules about how escrow money can be accessed, the Internal Revenue Code does not directly regulate how the QI invests proceeds from an LKE transaction. In essence, unless the taxpayer stipulates preferences or restrictions, the QI controls use of the funds.


“If you don’t say where you want your funds invested and at what type of interest, you’re allowing the QI to decide where to put those funds,” said Abrahm at Accruit.

He recommends that all taxpayers discuss the restrictions of proceeds and investment vehicles available for their funds with their QI.

“QIs aren’t asked to take the funds, get the highest return and buy something later,” said Abrahm. “The focus of the QI should be to protect the principal, not maximize the return on funds.

FEA is currently working at both state and national levels toward the possible creation of regulations that could place parameters on QIs’ use of funds. And tax adviser Pierson says that might not be an altogether bad idea.

“I hate to see too many rules,” he added. “It can get so onerous that you can’t even follow them. But on the other hand, to protect the taxpayer, the equipment dealer, probably there should be rules beyond the [current] IRS regulations.”

Since use of exchange proceeds is not clearly defined, experts observe in the alleged misconduct cases that the QI companies may have commingled client money rather than keeping separate accounts for each client.

Abrahm says that Accruit maintains separate interest-bearing accounts at leading financial institutions for each AED member client.

Still a Viable Option
Sources agree that despite the two instances of alleged wrongdoing, no one should be deterred from considering like-kind exchange.


“There are enough of us out there doing the right thing with the right safeguards that consumers should not be concerned with using like-kind exchange,” said Clementi-Ryan. “It’s still a very safe vehicle. [But] knowing it’s unregulated, you have to do your homework.”

Dealers have the potential to increase their purchasing power by utilizing like-kind exchange and deferring the capital gains taxes on their rental fleets. Foster notes that most equipment gain is taxed at ordinary income rates, so there are significant taxes to defer — and benefit to be derived.


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