In 1991, the Department of Treasury published regulations creating four safe harbors defining conditions and constraints to determine whether the taxpayer is in actual or constructive receipt of money or other property for the intent of Internal Revenue Code (IRC) § 1031. IRC Section 1031 states “no gain or loss is recognized when property held for productive use in a trade, business or investment is exchanged for property held for productive use in a trade, business or investment.” The outcome of the code allows taxpayers to defer the capital gain and recaptured depreciation taxes for real and personal property held for use in a business or investment.
Constructive Receipt
The purpose of the safe harbors is to prevent the taxpayer from the receipt or control over transactional proceeds. For example, in a property closing, a settlement agent may mistakenly complete a 1031 exchange without a Qualified Intermediary (QI) by transferring the proceeds from one escrow to another, believing that is acceptable when in fact, the taxpayer as principal is deemed to have received the transactional proceeds given the settlement agent is the taxpayer’s agent, violating the g(6) constructive receipt limitations and invalidating the exchange. Equally important , there must be a series of agreements supporting the taxpayer’s intent to initiate a 1031 exchange in accordance with IRC regulations, linking the interdependent transactions of the property disposition and acquisition.
Safe Harbors
Given the exchanging taxpayer cannot have access to the proceeds between the time the relinquished and replacement property are sold and acquired, the regulations provide protection for the taxpayer, preventing possession of the cash. Known as Safe Harbors, the most common are a QI and Qualified Escrow Holder. The independent, arms-length QI is unrelated, a non-employee and under Safe Harbor No. 3, not considered an agent of the taxpayer for purposes of the 1031 exchange.
Taxpayer assignments enable the QI to sell and acquire the old and new property with notice of assignments and an exchange agreement drafted to support the 1031 requirements. The QI will also typically hold the exchange proceeds preventing taxpayer access until the funds are needed for the replacement property. The funds are often held in qualified escrow accounts requiring dual signatures or accounts requiring personal identification numbers for disbursement.
Care should be exercised when selecting a QI, given the industry is not regulated though the Bureau of Consumer Financial Protection is tasked with developing regulations.
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