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If you sell investment property and use a Section 1031 Exchange to defer taxes on the capital gains, you could end up losing all of your sales proceeds, still owing the capital gains tax to the IRS, and have no effective recourse.Section 1031 of the Internal Revenue Code allows a taxpayer to sell a “property held for productive use in a trade or business or for investment,” called the relinquished property, and defer taxes on the capital gains.This is done by purchasing another investment property, called the replacement property, within 180 days, and using the net sales proceeds from the sale of the relinquished property in the purchase of the new property.One of the rules, however, in qualifying for a Section 1031 Like Kind Exchange, is that an independent third party must take possession of the net sales proceeds and hold them until the closing on the purchase of the replacement property, so that you never have possession of, nor control over, the funds.Proving to the IRS that you did not have “possession of, nor control over, the funds” and that the third party really was “independent” can be a problem later.The agency is not likely to just take your word for it.A qualified escrow account is where your escrow agreement with the qualified intermediary expressly limits your rights to receive, pledge, borrow or obtain any benefits from funds held in the escrow account, but the funds are held in your name and not the name of the qualified intermediary.A qualified trust is just that, a trust, and you are the beneficiary.
There are two ways to do this: with a qualified escrow account or a qualified trust account.
So, a system has been put in place to provide you a “safe harbor” for this requirement.
If you do this, the IRS will assume that you have satisfied the requirement of not having possession of, nor control over, the net sales proceeds.
The qualified intermediary has traditionally used the funds to speculate in the stock market, or wherever they can find the highest return, since they keep all of the profits.
But because high returns are accompanied by high risks, the funds have been lost or stolen by the qualified intermediary.