If you’re considering a 1031 tax exchange to defer payment of capital gains tax on your real estate investment, it’s important that you understand the basics of the 1031 exchange process. As a general rule, savvy investors understand the low-level nuts and bolts of the transaction – but things can get a little sticky when it comes to choosing a qualified intermediary.

The basis of a successful 1031 tax exchange is formal non-recognition of gain. For the gain to be officially unrecognized, however, the IRS requires that you (as the exchanger) never take possession of the proceeds from your sale. The use of a qualified intermediary makes non-recognition of gain possible because that qualified intermediary holds the proceeds from the sale of your relinquished property before they are used to purchase your intended replacement property. To put it simply, a qualified intermediary is a required part of any 1031 exchange.

The qualified intermediary is also responsible for a number of basic paper-handling tasks on a nuts-and-bolts level, including tracking paperwork and ensuring that money is wired to the right place at the right time. Many potential exchangers, then, recognize the importance of these duties and decide that they would like to use an individual or entity with which they have an existing relationship.

In theory, this makes perfect sense – but 1031 tax exchange regulations make this impossible (or, at the very least, difficult). For starters, the qualified intermediary must be an entity that is approved via regulatory agencies for this activity (which means that your qualified intermediary can’t just be your mom or your neighbor). Secondly, your qualified intermediary cannot be an agent of the exchanger (meaning you). This means that you cannot employ as a qualified intermediary anyone who has acted as your accountant, employee, attorney, investment banker, or real estate agent within the past two years.

The purpose of this rule is to guarantee that the qualified intermediary is an uninvolved third party who will not be tempted to do anything untoward with the proceeds of the first sale. Remember that the role of the qualified intermediary is critical to the success of any 1031 exchange – and the regulatory agencies are simply not interested in the possibility of any mistreatment of funds that are receiving the benefits of tax deferral.

Tax-sheltered 1031 exchanges, then, are carefully designed legal transactions that are protected by a variety of safeguards. These safeguards are in place to help preserve the integrity of the transaction – and the use of an approved, uninvolved third party in the role of qualified intermediary is critical for the success of the process.