The Importance of Safe Harbors in a 1031 Exchange

When the concept of #1031 exchanges were first introduced in the early 1920s, the original intent was to aid two parties in the simultaneous exchange of real estate. Party A and Party B exchanged real estate with each other and contributed cash if the selling and purchase prices didn’t equalize out. It worked great, until it didn’t. After all, how often could an investor find another similarly situated investor to exchange property with? Gradually, deferred exchanges became the norm.

Yet the deferred exchanges ran afoul of then-existing IRS regulations. But the government recognized the importance of delayed exchanges to the economy and new legislation came to the rescue in the 1991 tax deferred exchange regulations. It was then that the idea of “safe harbors” came into play. These safe harbors were designed to further protect investors when they engaged in anything other than a simultaneous exchange.

So what are these safe harbors? And why are they important? A few of the most important ones include:

Qualified Intermediary Safe Harbor

The key to deferred exchanges, the qualified intermediary is the middle person or entity that makes a delayed exchange possible. They are the ones who hold the sale proceeds and title to the new property to avoid an investor having actual or constructive receipt of money during the transactions. And while there are no formal requirements for who can be a qualified intermediary, there are restrictions on who cannot. No family members or any of the investor’s personal accountants, financial advisors or lawyers can take on this role.

Qualified Escrow and Qualified Trust Safe Harbor

Not having actual or constructive receipt of the relinquished property’s sale proceeds is a key factor in a successful 1031 exchange. To make this possible, the IRS allows for sale proceeds to be deposited into a qualified escrow or trust account subject to specific rules that prohibit the investor from having actual or constructive access to the funds. The qualified intermediary usually administers the accounts that hold these funds during the transaction.

If you’re planning a 1031 exchange of your own, be sure you understand not only safe harbors but also the stringent time requirements that govern the transactions. Visit our website to learn more about these powerful tax deferral tools and our qualified intermediary and replacement property locator services.