Regulate 1031 Qualified Intermediaries?

February 18, 2020

The 1031 industry is little known outside the world of tax attorneys, CPAs and real estate professionals. To most people, 1031 exchanges are a foreign concept, something far-removed from what is relevant in their daily life. But, obscure as it may be, Sec 1031 qualified intermediaries see many millions of dollars pass through their hands on a yearly basis.

Sec 1031 Qualified Intermediaries Almost Eliminated

Thousands of investors utilize the provisions of IRC Section 1031 every year to defer whatever tax liability they may owe to the IRS. In fact, the 1031 industry has grown so much, the provisions of Section 1031 have nearly been eliminated on several occasions. When the TCJA was being formulated, for instance, Section 1031 was almost removed. There was an argument made that these provisions constituted a tax “loophole” and that the federal government was being deprived of revenue. Fortunately for taxpayers, real estate 1031 exchanges were preserved as lawmakers came to realize the universal benefits provided by this section. 

Potential Regulations

In this post, we will discuss the possibility of the federal government regulating the 1031 industry in a way which mirrors its regulation of the stock market. As we know, the federal government regulates the stock market through the Securities and Exchange Commission (SEC). Given the rise of 1031 industry, there may be a compelling argument that this industry should also be regulated. The 1031 industry has witnessed a number of scandals which may have been preventable. Federal regulation might also be beneficial in order to promote a more predictable, stable market. Let’s discuss this matter in detail.  

The Current State of the 1031 Industry 

As of right now, there is no 1031 industry regulation at the federal level. There have been some developments in the 1031 industry which have attempted to create some level of predictability and consumer protection. For instance, the Federation of Exchange Accommodators (FEA) provides an avenue for intermediaries to certify their expertise and reliability. However, membership in the FEA is not a requirement for intermediaries across the nation. Furthermore, states are free to craft their own requirements for intermediaries provided that those requirements comply with Section 1031 and its Treasury Regulations. This wide latitude in state lawmaking means that there is great variance in requirements between states. This type of variance tends to decrease consumer confidence and increase risk of scandal.  

Arguments in Favor of Federal Regulation 

Simply put, regulating the 1031 industry at the federal level would tighten up the risk of financial harm to taxpayers who utilize this section. If there were consistency in the requirements for intermediaries throughout the nation, taxpayers would have less cause for worry regarding the security of their funds. The tax code and Treasury Regulations clearly delineate who is ineligible to act as an intermediary, but eligible persons have few barriers to entry.

State Rules

In some states, for instance, it is possible for a single individual to act as the intermediary without any evidence of training, certification or insurance. At present, there are no federal regulations regarding how client funds have to be handled once a given transaction has taken place. Intermediaries compete with each other in their handling of client funds and risk management. But there is an argument that this behavior should be driven by regulation rather than market competition. 

As mentioned, there have been a number of scandals in the 1031 industry. There are cases of Sec 1031 qualified intermediaries literally running off with client funds and clients being swindled out of millions of dollars. Federal regulation would be one step toward lessening the risk of financial crimes and scandal. 

A More Stable Marketplace?

Federal regulation would also create a more stable marketplace and possibly lead to more transactions. Variance in requirements at the state level lowers taxpayer confidence in the industry. Many taxpayers who are unfamiliar with the industry shy away from conducting a transaction. That’s often because of the lack of uniformity and predictability. This is true even when conducting a transaction may be in that taxpayer’s financial interest. One reason why people feel comfortable investing in the stock market is of the federal oversight given to the markets. If the 1031 industry went in the same direction, it’s very reasonable to assume that transaction volume would increase. 

Arguments Against Federal Regulation 

Obviously, no one disputes the desirability of increasing client protection or improving the conditions of the marketplace. But there is a question about whether imposing regulations at the federal level is a financially sensible proposition. The 1031 industry is considerably smaller than the stock market. Implementing and enforcing federal regulations would require a great deal of time and resources.

Two Problems

These are two things which the federal government does not have in great abundance. The first is that the federal government already has a difficult time enforcing its current regulations. Adding more regulations to the list may simply not be feasible. The second is the notion that taxpayers themselves need to exercise personal responsibility when selecting an intermediary. When a taxpayer chooses a Sec 1031 qualified intermediary, it’s a huge decision. That’s because even a relatively small transaction still typically involves many thousands of dollars. Taxpayers should not need tight federal guidelines to help them choose sensibly.  

In the end, the right approach is probably somewhere in the middle. The 1031 industry has grown to the point where some level of uniformity is desirable. This would reduce variance at the state level. But creating a parallel of the SEC to police intermediaries seems excessive. Particularly given the size of the industry and resources required to do so. 

Call Us For More Information

Whether federal regulations develop, it’s wise for taxpayers to use expert counsel for a 1031 exchange. At Mackay, Caswell & Callahan, P.C., we have attorneys who are well-versed in the various rules of Section 1031. As we’ve seen, this section is a veritable maze of complex rules and regulations. No taxpayer should venture out alone. Before you select an intermediary, you should obtain a qualified tax attorney. They can help you understand the process and the potential issues involved. Of course, our attorneys also assist in other areas, such as wage garnishments and IRS tax debt resolution. If you have a tax issue, contact one of our top New York City tax attorneys for assistance today. 

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