In an attempt to provide clear rules for "typical" deferred exchange transactions, the Treasury Regulations provide four safe harbor tests. These safe harbors define the edges of the envelope of safety. Transactions structured within the safe harbors will result in a determination that the Taxpayer is not in actual or constructive receipt of money or other property for purposes of the Regulations.
1. Transferee's exchange obligation secured by a mortgage, a standby letter of credit, or a third party guarantee
Under the first safe harbor, the obligation of the Taxpayer's purchaser to transfer the Replacement Property to the Taxpayer is permitted to be secured or guaranteed by:
- A: A mortgage, deed of trust, or other security interest in property (other than cash or a cash equivalent);
- B: A standby letter of credit which satisfies all of the requirements of Code Section 15A.453-1(b)(3)(iii) and which does not allow the Taxpayer to draw on such standby letter of credit except upon a default of the purchaser’s obligation to transfer like-kind Replacement Property; or
- C: A guarantee of a third party.
In practice, this safe harbor is rarely used. This security arrangement can be compared to the unsecured promise that T.J. Starker received from his purchaser, Crown Zellerbach Corporation. Crown agreed to acquire and convey Replacement Property to Starker, that Starker would designate over an agreed upon period of time.
2. Qualified Trust or Qualified Escrow
Under the second safe harbor, the obligation of the Taxpayer's purchaser to transfer the Replacement Property is permitted to be secured by cash or a cash equivalent if such cash or cash equivalent is held in a qualified trust or a qualified escrow.
A trust or escrow is "qualified" if the trustee or escrowee is not a "disqualified person", and the Taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in escrow or trust are limited to certain specified circumstances described in Treas. Reg. § 1.1031(k)-1(g)(6) (also referred to as the "(g)(6)" Restrictions).
3. Qualified Intermediary
Under the third safe harbor, deferred exchanges are permitted to be facilitated by the use of a Qualified Intermediary if the Taxpayer's rights to receive money or other property are limited to those circumstances described at Treas. Reg. § 1.1031(k)-1(g)(6).
A Qualified Intermediary is a person who is not the Taxpayer or a Disqualified Person and who, for a fee, acts to facilitate a deferred exchange by entering into an agreement with the Taxpayer for the exchange of properties. Pursuant to the agreement, the Qualified Intermediary acquires the Relinquished Property from the Taxpayer, transfers the Relinquished Property to a purchaser, acquires the Replacement Property, and transfers the Replacement Property to the Taxpayer.
The Qualified Intermediary may be deemed to have acquired property even if the Qualified Intermediary never acquires legal title to the property. Consistent with Revenue Ruling 90-34, LR.C. 1990-16 (April 16, 1990), the transfer of property in a deferred exchange that is facilitated by the use of a Qualified Intermediary may occur via a "direct deed" of legal title by the current owner of the property to its ultimate owner.
Acquisition by Qualified Intermediary
A Qualified Intermediary is treated as acquiring and transferring property if the Qualified Intermediary:
- A: Acquires and transfers legal title to that property.
- B: Enters into an agreement with a person other than the Taxpayer for the transfer of the Relinquished Property to that person.
- C: Enters into an agreement with the Owner of Replacement Property for the transfer of that property and, pursuant to that agreement, the Replacement Property is transferred to the Taxpayer.
- D: Accepts the assignment of the rights to an agreement and all parties to the agreement are notified in writing of the assignment on or before the date of the relevant transfer of property.
4. Interest Income
Under the fourth safe harbor, the Taxpayer is permitted to receive interest or a growth factor with respect to the deferred exchange, provided that the Taxpayer's rights to receive such interest or growth factor are limited to certain specified circumstances. Such interest or growth factor will be treated as interest regardless of whether it is paid in cash or in property (including property of a like-kind).
Restrictions on Safe Harbors - The "(g)(6)" Restrictions
In order for an escrow or trust account to be a "qualified" account for purposes of the Treasury Regulations, and to avoid the issue of constructive receipt of funds by the Taxpayer, the account must contain restrictions on the Taxpayer's rights to receive the cash. Specifically, the Regulations require that the Taxpayer not have the right to receive money or other property until:
- A: After the end of the Identification Period, if no Replacement Property is identified, or
- B: After the end of the Identification Period if the Taxpayer has received all of the identified Replacement Property to which the Taxpayer is entitled, or
- C: After the end of the Identification Period if there is an occurrence of a material and substantial contingency that:
1: Relates to the exchange,
2: Is provided for in writing, and
3: Is beyond the control of the Taxpayer and of any "Disqualified Person," other than the person obligated to transfer the Replacement Property to the Taxpayer, or
D: The end of the 180 - day Exchange Period.
Abiding by the (g)(6) restrictions is critical to every properly structured exchange. Advance planning, such as beginning the search for Replacement Property prior to transferring Relinquished Property, can help minimize the likelihood that a Taxpayer’s cash is unavailable for distribution as a result of the (g)(6) restrictions.
Dealing with the Consequences of the "(g)(6)" Restrictions
These restrictions can be frustrating for and seem arbitrary to Taxpayers and their advisors when they find they are unable to acquire an identified property and wish to take the cash out of their exchange account prior to the end of the exchange period. In the spring of 2000, CDEC applied to the IRS for a private ruling [PLR 200027028] in an attempt to clarify the definition of "material and substantial contingency". In the ruling request, two possible scenarios were set forth:
- A: Taxpayer identifies three replacement properties with the intent of acquiring all three properties. Taxpayer acquires two of the properties, but is unable to negotiate the acquisition of the third property, leaving a balance in the exchange account.
- B: Taxpayer identifies one Replacement Property but is unable to reach agreement for the purchase of that property.
Question: Can the cash be released from the qualified account prior to the end of the Exchange Period?
Question: Is the Taxpayer's inability to negotiate the acquisition of Replacement Property a "material and substantial contingency" that relates to the exchange, is provided for in writing, and is beyond the control of the Taxpayer or any Disqualified Person?
The IRS concluded that neither of these scenarios would justify early release of the cash in the exchange account and that the only contingencies that would meet this criteria of the Regulation are:
- A: A government agency's seizure, requisition, or condemnation of the Replacement Property or a government agency's failure to approve a request to rezone or approve the transfer of the Replacement Property, or
- B: An act beyond anyone's control (i.e., destruction of the Replacement Property).