1031 Exchange Safe Harbor Rules: What You Need to Know

Real estate investors who sell investment properties will have to pay significant capital gains taxes on the sale proceeds unless they reinvest those funds into a similar replacement asset.

This process is known as a 1031 exchange, and it’s an important tool for investors seeking to defer capital gains tax liabilities. A few other potential benefits of 1031 exchanges include the ability to invest in new markets, trading up for higher-value assets, and asset appreciation over time. There are also some potential drawbacks to 1031 exchanges, including strict timelines and deadlines that must be met in order to ensure a successful exchange.

Some safe harbor requirements must be satisfied as well. In this article we’ll outline the 1031 exchange safe harbor rules to provide real property investors with a better understanding of the exchange process and how to meet safe harbor guidelines.

1031 Exchange Safe Harbor Rules for Residential Properties

The last thing any exchangor wants is to have their 1031 exchange disqualified or audited by the Internal Revenue Service. 

Investors must follow a strict set of rules when completing 1031 exchanges. For example, you can’t take possession of any sale proceeds -- they must be held by a qualified intermediary (QI). Another key element to an exchange is that the replacement property must be held for investment purposes or for productive use in a trade or business -- you can’t exchange with the hopes that you’ll realize financial gain through asset appreciation.

The IRS provides clear safe harbor guidance on how to meet the qualifying investment requirement.

IRS Revenue Procedure 2008-18 states the standards for investment properties. These rules below apply to your original investment property, known as the relinquished asset in the exchange.

1. You must have held the asset for a minimum of two years. This is called the “qualifying use” period.
2. Within each 12-month period of that 24-month timeframe, you must have rented the dwelling to another person at fair market value for a minimum of 14 days.
3. You can’t have used the dwelling yourself more than 14 days, or 10 percent of the days you rented the property out to others in each 12-month period.

These same safe harbor rules apply to the replacement asset as well. You have to hold it for at least two years, derive a minimum of 14 days rental income each year, and you can’t use it for more than 14 days each year (or the 10 percent, when applicable). The fair market value language is important too. Renting out your 1031 exchange property to a friend or family member at a rate well below market value could result in a disqualified or challenged exchange by the IRS.

These rules discourage “fix-and-flippers” from avoiding capital gains taxes when they buy and sell residential investment properties. They also keep investors from purchasing second homes through a 1031 exchange -- the property must be purchased as an investment from which you derive rental income. 

1031 Safe Harbor Rules for Commercial Property Investors

Commercial property owners will have to meet the following safe harbors to ensure their exchanges aren’t challenged:

• Use of a QI. You must engage an unrelated third party to acquire a replacement asset. The QI holds all sale proceeds from your relinquished asset and facilitates all paperwork necessary to complete the exchange.
• Holding period. This is a key element of exchanges for commercial properties. The holding period goes a long way toward determining the initial intent of the exchanged asset -- investment must be your primary motivation. While there’s no clear language from the IRS on safe harbor for holding periods, most tax and legal professionals agree that two years is the minimum requirement.

Holding an asset strictly for sale will likely prove problematic for exchangors. Renting it out, meanwhile, provides safe harbor that the property was purchased as an investment.

The Bottom Line

The safe harbor rules for residential properties acquired through a 1031 exchange are pretty clear. There’s less clarity when it comes to commercial properties because there’s no set time for a holding period to establish safe harbor.

Investors can avoid any potential audit of their exchanges by demonstrating their intent that the property was purchased as an investment by renting it out at fair market value. Advertising, listing the property for rent, and similar marketing efforts also can provide this important safe harbor.