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What are the 1031 Safe Harbors?

At its most basic level, a Sec. 1031 exchange is all about insulating taxpayers from receiving taxable gain from a sale. In addition to providing counsel, the function of a Sec. 1031 intermediary is to prevent the taxpayer from receiving sale proceeds. Intermediaries are therefore necessary in every type of 1031 transaction, except for direct swaps. If a taxpayer closes a sale without an intermediary, then the taxpayer will have receipt of the funds and this will trigger tax consequences. The Treasury Regulations spell out exactly the conditions which will not factor into a determination of whether the taxpayer is in receipt of funds. These conditions are the Sec. 1031 like kind exchange “safe harbors”. There are four of them. If taxpayers work within these safe harbors, they avoid receipt and can conduct a successful exchange.

In this post, we will go over each of the four safe harbors of the Treasury Regulations. We will show exactly how each safe harbor operates as well as its general significance. These safe harbors provide the overall framework for the receipt of funds in 1031 transactions. The term “safe harbor” exists elsewhere in the Sec. 1031 lexicon. Most commonly it’s associated with the safe harbor provided by the IRS Revenue Procedure 2000-37, which applies to reverse exchanges. Let’s go over each of the safe harbors found under subsection 1031(g). 

1031(g)(2) – Security or Guarantee Arrangements 

Under paragraph (2), receipt (or non-receipt) is made without reference to whether the transferee of the replacement property secures the transaction with a security or guarantee arrangement. Specifically, the transferee may secure the transaction through a mortgage, deed of trust, or other security interest in property (other than cash). What’s more, the transferee may also use either a standby letter of credit or a guarantee from a third party. Importantly, these provisions cease to apply the moment that the taxpayer has unrestricted access to money or property under one of these arrangements.  

In other words, the Treasury Regulations are allowing taxpayers to have a secured transaction without worrying that this will impact a determination of receipt.  

1031(g)(3) – Qualified Escrow Accounts & Qualified Trusts 

This paragraph adds to the previous paragraph. Under paragraph (3), the transferee of the replacement property may secure the transaction with cash. But, that cash (or cash equivalent) must be held in a qualified escrow account or qualified trust account. The paragraph goes on further to provide definition for both a qualified escrow account and qualified trust account. In both cases, a “disqualified person” cannot be the person who establishes the account. The paragraph also specifies that these provisions cease to operate if the taxpayer obtains unrestricted ability to the cash. Having such an unrestricted ability will trigger constructive receipt.   

1031(g)(4) – Qualified Intermediaries 

This is the paragraph which really creates the 1031 intermediary industry. This paragraph states that the transfer of relinquished property and receipt of replacement property using an intermediary qualifies as an exchange. The paragraph further states that a qualified intermediary is not be treated as an agent of the taxpayer. This allows the intermediary to hold the money from the sale of the relinquished property prior to the transfer of the replacement property. This holding does not qualify as receipt by the taxpayer given that the intermediary is not treated as an agent.

The paragraph goes on to give a precise definition of a qualified intermediary for the purposes of Sec. 1031. It also states that this provision ceases to operate if the intermediary doesn’t limit the taxpayer’s ability to receive sale proceeds. 

1031(g)(5) – Interest and Growth Factors 

This provision is a result of the famous Starker case of the 1970s. The receipt determination is made without respect to any interest or growth factor which the taxpayer may be entitled to as a consequence of the exchange. However, the (g)(6) restrictions (which we’ve discussed before) spell out the conditions which must be in place to make this work. Just as with the other safe harbors, interest and growth factors must be off limits to taxpayers during the course of the exchange. This safe harbor ceases to operate if the taxpayer violates this rule. 

These four safe harbors are extremely important provisions in Sec. 1031. These safe harbors help us understand the contours of actual and constructive receipt and, as a consequence, the full mechanics of 1031 transactions. As mentioned, understanding actual and constructive receipt is very important because the entire purpose of a 1031 like kind exchange is to prevent receipt by the taxpayer. In the future, we will revisit receipt by looking at a few concrete scenarios which test the boundaries of this concept. 

Our New York City Tax Attorneys Can Help

At Mackay, Caswell & Callahan, P.C., we help clients navigate through the complex world of tax. We take pride in assisting our clients with various tax issues, including tax debt resolution, Sec. 1031 exchanges, state tax issues and so forth. Tax is a very complex and intimidating field. This is precisely why you shouldn’t try to figure out these issues all by yourself. It’s almost always advisable to have an expert on your side to help you solve whatever problem you have. If you need to speak with an expert, reach out and one of our top New York City tax attorneys will get back to you immediately. 

Image credit: KJGarbutt