Disqualified Persons

The definition matters more than its length suggests. Nothing in federal tax law requires an intermediary to be licensed, bonded, capitalized, or independent in any general sense, as 27.3 observed. The disqualified person rules are the only independence requirement the regulation imposes, and they do that work alone.

28.1 The agency lookback

A disqualified person is a person described in any of three paragraphs of the regulation, and the three are cumulative rather than alternative.¹ The first category is the taxpayer's agent. The person is a disqualified person if the person is the agent of the taxpayer at the time of the transaction.²

The regulation does not leave agency to common law. It supplies a conclusive rule for a listed set of relationships: a person who has acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the two-year period ending on the date of the transfer of the first of the relinquished properties is treated as an agent of the taxpayer at the time of the transaction.³

Four features of that sentence deserve separate attention because each disposes of an argument someone will make.

The lookback is two years and it is measured to a fixed date. The period ends on the date of the transfer of the first of the relinquished properties, which in a multi-property exchange is the earliest closing, consistent with the timing rule at 26.3. The date is knowable in advance, so the conflict check is a computation rather than a judgment.

There is no materiality qualifier. The regulation asks whether the person acted in one of the listed capacities, not how much work was done, how long ago within the period, or whether the matter had anything to do with real estate. A single engagement two years less a day before closing is within the period.

The list is of capacities, not of licenses. Employee, attorney, accountant, investment banker or broker, real estate agent or broker. A person who performed those functions is captured whether or not the relationship was formalized.

The rule is a floor and not a ceiling. The listed relationships are treated as agency. Actual agency at the time of the transaction disqualifies a person independently, whether or not the person appears on the list.

Two categories of services are excluded from the lookback, and they are what make the exchange industry possible.

The first is services for the taxpayer with respect to exchanges of property intended to qualify for nonrecognition of gain or loss under section 1031.⁴ A person who has done nothing for the taxpayer but prior exchanges is not disqualified on that account, which is why a repeat intermediary may be used again.

The second is routine financial, title insurance, escrow, or trust services for the taxpayer by a financial institution, title insurance company, or escrow company.⁵ Note that this exclusion is doubly conditioned. It covers a listed service performed by a listed kind of provider. Routine escrow services by an escrow company are excluded. Non-routine services, or the same services from a provider outside the listed categories, are not.

The regulation's first example states the rule and its converse in a single breath. Where the intermediary had rendered accounting services to the taxpayer within the two-year period on matters other than section 1031 exchanges, the intermediary was a disqualified person. Had the accountant rendered no services in that period, or had the services within that period related only to exchanges intended to qualify under section 1031, the accountant would not have been a disqualified person.⁶

28.2 Attribution among related persons

The second and third categories reach relationships rather than services, and they operate by importing two related party provisions with a single alteration.

Related to the taxpayer. A person is disqualified if the person and the taxpayer bear a relationship described in either section 267(b) or section 707(b), determined by substituting ten percent for fifty percent each place it appears.⁷

Section 267(b) lists thirteen relationships. The ones that matter in exchange practice are members of a family; an individual and a corporation more than the stated percentage in value of the outstanding stock of which is owned directly or indirectly by or for the individual; a grantor and a fiduciary of a trust; a fiduciary and a beneficiary; and a corporation and a partnership owned by the same persons above the stated percentage.⁸

The family definition is narrower than clients expect and is not affected by the percentage substitution, because it contains no percentage. The family of an individual includes only brothers and sisters, whether by the whole or half blood, a spouse, ancestors, and lineal descendants.⁹ In-laws, aunts and uncles, nieces and nephews, and cousins are outside it. A taxpayer's brother cannot serve as intermediary. A taxpayer's brother-in-law is not disqualified on this ground, which surprises people in both directions.

Section 707(b) reaches a partnership and a person owning, directly or indirectly, more than the stated percentage of the capital interest or the profits interest in the partnership, and two partnerships in which the same persons own more than the stated percentage.¹⁰

The substitution is the operative move. Reading these provisions at ten percent rather than fifty makes a great many ordinary business relationships disqualifying. A taxpayer who owns twelve percent of a title company has a disqualified title company. A taxpayer holding an eleven percent profits interest in a partnership has a disqualified partnership.

Related to the taxpayer's agent. The third category is second order and is the one that is missed. A person is disqualified if that person and a person described in the agency category bear a relationship described in section 267(b) or section 707(b), again substituting ten percent for fifty percent.¹¹

The chain runs from the taxpayer to the taxpayer's lawyer or accountant, and then from that person to anyone sufficiently related to them. An intermediary owned by the taxpayer's accounting firm is disqualified even though the intermediary itself never served the taxpayer.

The regulation's third example marks the boundary with unusual precision, and the arithmetic is the point. An intermediary corporation was owned by ten law firms, each holding exactly ten percent of the stock. One of those firms had rendered legal advice to the taxpayer within the two-year period on matters unrelated to exchanges, and that firm's managing partner was also the president of the intermediary. The partner and the firm were disqualified persons. The intermediary was not, because neither owned, directly or indirectly, more than ten percent of its stock. The regulation adds that the partner's participation in the management of the intermediary did not make the intermediary a disqualified person either.¹²

Exactly ten percent is not more than ten percent. Ownership rather than management control is what the provision measures. Both propositions are useful and both are dangerous to rely on without counting the constructive ownership rules, which apply to these determinations as they do generally.

The bank exception. For transfers of relinquished property made on or after January 17, 2001, the second order rule does not apply to a bank as defined in section 581, or to a bank affiliate, where the entity would be disqualified solely because it is a member of the same controlled group as a person that has provided investment banking or brokerage services to the taxpayer within the two-year period. A bank affiliate for this purpose is a corporation whose principal activity is rendering services to facilitate exchanges intended to qualify under section 1031 and all of whose stock is owned by either a bank or a bank holding company.¹³

The exception is narrow and its narrowness is deliberate. It reaches only investment banking and brokerage services, only through the controlled group route, and only for banks and dedicated exchange subsidiaries of banks. It does not rescue a bank affiliate that is disqualified for any other reason.

28.3 The attorney, accountant, and broker problem

The listed capacities are precisely the professionals a client already trusts, and the client's instinct is to ask one of them to hold the money. That instinct must be refused, and the refusal is easier to deliver if the rule is stated accurately rather than as the slogan it usually becomes.

The slogan is that your attorney cannot be your intermediary. The rule is narrower and more useful. An attorney is disqualified if the attorney acted as the taxpayer's attorney within the two-year period ending on the first relinquished property transfer, on any matter other than exchanges intended to qualify under section 1031.¹⁴ An attorney who has never represented the taxpayer is not disqualified on this ground. An attorney whose only work for the taxpayer in that period was exchange work is not disqualified either, by the express terms of the exclusion.¹⁵

The same analysis applies to the accountant, and the regulation's first example is an accountant. It applies to the real estate broker who listed the relinquished property, who is a real estate agent or broker for the taxpayer and is disqualified for two years afterward. It applies to the taxpayer's employee, which forecloses the arrangement in which a controlled entity's officer holds the funds.

Three practical consequences.

Being disqualified does not disable the professional from the engagement. It disables the professional from occupying a safe harbor role. The taxpayer's regular attorney may structure the exchange, draft or review every document, negotiate with the intermediary, and advise throughout. What that attorney may not do is serve as the qualified intermediary, hold funds as escrow holder or trustee, or, ordinarily, receive the identification. Clients conflate the two and should be told the difference plainly.

The identification recipient rule is a separate trap. As 25.1 developed, an identification must go to the person obligated to transfer the replacement property, or to a person involved in the exchange who is not the taxpayer and not a disqualified person. An identification sent only to the taxpayer's own lawyer or accountant is therefore ordinarily void, and the failure is invisible until examination. The intermediary is the correct recipient.

A prior exchange relationship is protected but a mixed relationship is not. The exclusion covers services with respect to section 1031 exchanges. A firm that has done exchange work and also prepared the client's returns has performed accounting services within the period, and the exchange exclusion does not launder the rest.

The regulation's second example is worth stating because it shows how far the two exclusions reach when they apply cleanly. An intermediary engaged in the trade or business of facilitating deferred exchanges was a wholly owned subsidiary of an escrow company that had performed routine escrow services for the taxpayer, and the intermediary itself had been retained by the taxpayer in prior section 1031 exchanges. The intermediary was not a disqualified person. The prior intermediary services fell within the exchange services exclusion, and the combination of the corporate relationship with the escrow company's routine escrow services fell within the routine services exclusion.¹⁶

That example is the charter of the institutional intermediary industry. Without it, every title and escrow company that had ever closed a transaction for a client would be barred from serving that client's exchange.

28.4 Structuring around disqualification

The disqualified person concept is generally discussed as though its only application were the identity of the intermediary. It appears in five places in the regulation, and a structure can fail at any of them.

The escrow holder of a qualified escrow account must not be the taxpayer or a disqualified person. The trustee of a qualified trust must not be the taxpayer or a disqualified person, subject to the carve-out for the relationship the trust itself creates.¹⁷

The qualified intermediary must not be the taxpayer or a disqualified person.¹⁸

The recipient of an identification must not be the taxpayer or a disqualified person, unless that recipient is the person obligated to transfer the replacement property, in which case disqualification is irrelevant.¹⁹

The material and substantial contingency that permits early release of funds under 27.6 must be beyond the control of the taxpayer and of any disqualified person, other than the person obligated to transfer the replacement property.²⁰

Read together, these produce a short and reliable procedure.

Fix the date. The lookback ends on the transfer date of the first relinquished property. Compute it and use it for every determination in the transaction.

Run the check against the whole list of roles. Ask separately of the intermediary, the escrow holder or trustee, and the intended recipient of the identification whether that person is disqualified. Practitioners who ask the question once, about the intermediary, miss the escrow holder.

Check both directions of the relationship test. The taxpayer's relationships and the taxpayer's agents' relationships both matter, and the second order rule of 28.2 is where an otherwise careful structure fails.

Count at ten percent, and count constructively. A relationship that is comfortably outside section 267(b) at fifty percent may sit inside it at ten, and constructive ownership can supply the difference.

Document the conclusion. A memorandum stating the roles, the persons filling them, the lookback date, and the basis for concluding that none is disqualified costs an hour and is the only contemporaneous evidence that the question was considered.

The consequence of getting it wrong should be stated to the client in terms. There is no partial credit and no cure. If the intermediary is a disqualified person, the intermediary harbor is unavailable, agency is determined under general principles, and the taxpayer who transferred property to an agent holding the proceeds is in receipt of the proceeds. The transaction is the sale described at 24.1, and it cannot be repaired after closing.

The related party rules examined in Chapter 40 are a different regime and should not be confused with this one. Those rules test who the taxpayer exchanges with, apply section 267(b) and section 707(b) without the ten percent substitution, and carry their own two-year period measured from the exchange forward rather than backward. A person may be a disqualified person under this chapter and not a related person under Chapter 40, or the reverse.