| Limitations on The Safe Harbors: The (G)(6) Provisions |
| |
The Safe Harbors represent the Internal Revenue Service's position on how deferred exchanges should be structured. As long as a transaction is structured within the safe harbors, an exchange will not be challenged on the basis of constructive receipt. The 1991 Treasury Regulations for tax deferred exchanges under IRC §1031 establishes “safe harbors,” the use of which allow a taxpayer (Exchanger) to avoid actual or constructive receipt of money or other property for purposes of completing a 1031 exchange.
The safe harbors require the Exchange Agreement between the Exchanger and the Qualified Intermediary to expressly limit the Exchanger's right to “receive, pledge, borrow, or otherwise obtain the benefits of money or other property” before the end of the 180-day Exchange Period, except as permitted by Treasury Regulation §1.1031(k)-1(g)(6)(ii)-(iii). and Treas. Reg. §1.1031(k)-1(g)(6)(i). The safe harbors are not satisfied if these restrictions are not placed upon the Exchanger, even if the Exchanger never actually receives the exchange proceeds. The “cash out” provisions found in the Regulations allow the exchange agreement to remove these restrictions and grant the Exchanger access to the exchange proceeds before the end of the Exchange Period, but only under the following circumstances: |
| |
| (A) |
If the Exchanger has not identified Replacement Property by the end of the 45-day Identification Period, then the exchange can be terminated and the Exchanger has the right to the exchange proceeds at any time. |
| |
|
| |
|
For example: On April 1, the Exchanger transfers the Relinquished Property to a buyer. If the Exchanger fails to identify any Replacement Property on or before May 16, then the Exchanger may have access to the funds in the exchange account at any time after May 16. |
| |
|
| (B) |
If, after the end of the Identification Period, the Exchanger has identified Replacement Property and receives all of the identified Replacement Property to which the Exchanger is entitled under the exchange agreement, then the Exchanger has the right to receive any remaining exchange proceeds even if it is prior to the end of the 180-day Exchange Period. |
| |
|
| |
|
For example, if the Exchanger identified a single Replacement Property on May 15 and acquired that Replacement Property on May 25, then the Exchanger could demand the balance of the remaining exchange proceeds at any time after that date since the Exchanger had acquired all of the identified Replacement Property to which it is entitled under the exchange agreement. This provision is more problematic when the Exchanger identifies multiple replacement properties. For example: On April 1, the Exchanger transfers the Relinquished Property to a buyer and the Qualified Intermediary “QI” receives $500,000 in exchange proceeds. On or before May 16, the Exchanger properly identifies a ranch and two vacant lots as Replacement Property although the Exchanger only intends to acquire the ranch. The 180-day period expires on September 28. On August 28, QI uses $300,000 to acquire the ranch for the Exchanger as Replacement Property. The receipt of the remaining $200,000 exchange funds prior to the expiration of the 180-day period could constitute constructive receipt of the exchange funds and possibly jeopardize the tax-deferred nature of the entire transaction. |
| |
|
| (C) |
If, after the end of the Identification Period a material and substantial contingency occurs that: relates to the deferred exchange, is provided for in writing; and is beyond the control of the Exchanger and of any “disqualified person” other than the person obligated to transfer the Replacement Property to the Exchanger, then the Exchanger has the right to the exchange proceeds. Although the Treasury Regulations provide very few examples, zoning problems or unsatisfactory structural inspections may rise to the level of a “material and substantial contingency.” To avoid the possibility of constructive receipt of the exchange funds, the Exchanger should always consult with their tax advisor as to whether the occurrence of a particular contingency in their purchase contract could be considered a “material and substantial contingency” to qualify under this provision. |
| |
|
| Disqualified Parties |
| |
To qualify for tax deferred treatment and create a "safe harbor", the Qualified Intermediary must be someone other than the Exchanger (taxpayer) or a "disqualified person". Agents of the Exchanger at the time of the transaction are disqualified persons. Examples of agents include the Exchanger's attorney if they have acted as the Exchanger's agent within the two-year period ending on the date of the transfer of the Exchanger's first Relinquished Property. If an attorney has provided tax or legal services to the Exchanger within the two-year prescribed period, the attorney is a disqualified person. Attorneys performing services solely in connection with exchanges are exempted from the disqualified person rule. However, this exception is extremely limited and an attorney proceeding under this exception should do so with extreme caution since the Exchanger could suffer severe adverse tax consequences if the attorney is determined to be a disqualified person with respect to the Exchanger's exchange. If an attorney is a disqualified person, the following are also disqualified: the attorney's law firm, a partner in the law firm who owns more than a 10% interest in the firm, any entity in which such partner owns more than a 10% interest and any entity in which the law firm owns more than a 10% interest. This is because the regulations provide that a separate corporation or other entity in which the Exchanger or a disqualified person has a 10% or more interest also constitute a disqualified party. While the Exchanger's attorney should not act as the Qualified Intermediary, they are invaluable to the Exchanger for tax and legal advice during the exchange.
An IRC §1031 tax deferred exchange can fail if the Exchanger has "actual or constructive receipt" of exchange proceeds or other property. Therefore, it is essential for the Exchanger to retain a Qualified Intermediary to satisfy the necessary "safe harbor" requirements under Treas. Reg. §1.1031(k)-1(g)(4).
A "disqualified person" is defined in Treasury Regulation §1.1031(k)-1(k). A disqualified person is someone who is the agent of the Exchanger (taxpayer) at the time of the exchange. If a disqualified person performs the exchange and holds the exchange proceeds the exchange may fail if the IRS determines that as a result of the disqualified party's involvement the Exchanger had "actual or constructive" receipt of the exchange funds. For purposes of this Regulation, 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 preceding the date of the transfer of the first Relinquished Property by the Exchanger is treated as an agent of the Exchanger at the time of the exchange and, therefore, a disqualified person.
Other disqualified persons are any parties that are considered "related parties" to the Exchanger, or parties that are related to the Exchanger in that the Exchanger and the related party have more than a 10% interest in the respective related partnership, corporation or trust. To insure the safety of the exchange it is important to have a "safe harbor", such as the use of a Qualified Intermediary, against the actual or constructive receipt of the exchange proceeds or property that would otherwise occur by using a disqualified person who will be considered the agent of the Exchanger. If a Qualified Intermediary is retained, the determination as to whether the Exchanger is in actual or constructive receipt of the exchange proceeds or other property is made as if the Qualified Intermediary is not the Exchanger's agent per Treasury Regulations §1.1031(k)-1(g)(4)(i). |
| |
| |
|
|
