Undergoing a 1031 exchange is a strategic move that allows you to defer capital gains taxes. The IRS has many stipulations regarding these transactions to prevent abuse, with safe harbor rules providing definitive language for full compliance. However, some investors still choose to complete a non-safe harbor 1031 exchange due to special circumstances.
So, what is a non-safe harbor 1031 exchange? How can it still qualify for tax-deferral benefits? Realized 1031 explores this complex undertaking to help you gain a clearer idea.
Before we define non-safe harbor exchanges, let’s first discuss the safe harbor exchange and provide more context. A safe harbor in the context of a reverse 1031 exchange follows guidelines established by the IRS to provide clear protections for investors. Revenue Procedure 2000-37 outlines these rules, and they generally apply to reverse exchanges.
The most common scenario where non-safe harbor exchanges happen is during a reverse exchange. In this case, an investor acquires a replacement property before selling the relinquished property. To prevent the investor from holding the title of both the relinquished and replacement properties, the IRS requires the following.
If you were able to satisfy these rules during a reverse exchange, the IRS would respect the reverse exchange as a valid, tax-deferred transaction under the safe harbor. However, investors may face issues along the way that may seemingly disqualify them from tax deferral benefits. For example, selling the relinquished property may take longer than 180 days because of extensive repairs. In this case, the transaction may become a non-safe harbor exchange.
A non-safe harbor exchange is any type of exchange that doesn’t fully comply with IRS regulations. However, these are not automatically invalid. Instead, you have to prove to the IRS that the structure meets the core requirements set by Section 1031 of the Revenue Code.
The IRS evaluates whether you had control over the replacement property before completing the exchange through a benefits and burdens test. If you assume too many benefits and burdens of ownership, such as property expenses or rental income, before the official exchange, then the IRS may invalidate the transaction. As such, it’s important to consider factors like the following.
If the answer is “me” for most of these questions, then you increase the chances of the IRS disallowing the exchange. It must be the EAT that bears these responsibilities to maintain the integrity of the transaction.
There are a few court cases that helped demonstrate how non-safe harbor exchanges can still be valid, particularly if structured correctly. One of these landmark cases is Estate of George H. Bartell, Jr. v. Commissioner, wherein the Bartell company held the replacement property for 17 months before selling the relinquished property. A tax court ruled in favor of the Bartell company because the intent of the exchange still aligned with Section 1031’s tax-deferral principles.
There are cases when a Delaware Statutory Trust (DST) may become a non-safe harbor exchange.
Even so, the 1031 exchange involving the DST can still be valid provided that you can demonstrate your clear intent for investment and adherence to the fundamental principles of the like-kind exchange.
A non-safe harbor 1031 exchange can still be a valid, albeit risky, strategy for investors who cannot meet some IRS guidelines. It’s important to work with experts like us at Realized 1031 to help you navigate this process with confidence. Contact us to schedule an initial consultation.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.ipx1031.com/our-services/reverse-improvement-exchanges/revenue-procedure-2000-37/
https://www.thetaxadviser.com/issues/2017/may/non-safe-harbor-reverse-like-kind-exchange.html
https://taxnews.ey.com/news/2016-1417-court-holds-like-kind-exchange-is-not-self-exchange