The Safe Harbors

Paragraph (g) of the deferred exchange regulation sets forth four safe harbors, the use of which will result in a determination that the taxpayer is not in actual or constructive receipt of money or other property for purposes of section 1031. They are protective rather than exclusive. A taxpayer who falls outside a harbor is not thereby in receipt; the taxpayer is returned to the general principles examined in Chapter 29, which is a position no competent advisor plans to occupy.

Two features of the harbors should be fixed at the outset because they organize the whole chapter. Each harbor answers a different question, so the ordinary exchange uses more than one. And three of the four are conditioned on the same drafting requirement, the express limitation of the taxpayer's rights described in 27.6, which is therefore the single most consequential paragraph in the regulation.

27.1 Security and guarantee arrangements

The four harbors appear in paragraphs (g)(2) through (g)(5) of the regulation, and they are examined here in that order.¹

The first addresses the taxpayer who wants assurance that the replacement property will actually be delivered. The determination of whether the taxpayer is in actual or constructive receipt is made without regard to the fact that the transferee's obligation to transfer the replacement property is or may be secured or guaranteed by one or more of three things.²

The first is a mortgage, deed of trust, or other security interest in property, other than cash or a cash equivalent.

The second is a standby letter of credit which satisfies all the requirements of section 15A.453-1(b)(3)(iii) and which may not be drawn upon in the absence of a default of the transferee's obligation to transfer like-kind replacement property to the taxpayer. Both conditions are drafting requirements, and the second is the one that is botched. A letter of credit drawable on any breach, or on demand, is not within the harbor.

The third is a guarantee of a third party.

The harbor ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive money or other property pursuant to the security or guarantee arrangement.³

The parenthetical exclusion in the first item is the reason the next section exists. Security in property is permitted. Security in cash or a cash equivalent is not, and a taxpayer whose obligation is secured by cash must place that cash in a qualified escrow account or a qualified trust. That single exclusion is what drove the entire industry toward the structures examined in 27.2 and 27.3.

This harbor is now largely of historical and specialty interest, because the modern exchange routes cash through an intermediary rather than securing a promise. It remains relevant where the buyer of the relinquished property gives a note, where a seller of replacement property guarantees performance, and in structures adjacent to installment reporting.

27.2 Qualified escrow and qualified trust accounts

The second harbor supplies what the first withholds. Where the transferee's obligation is or may be secured by cash or a cash equivalent, the constructive receipt determination is made without regard to that security if the cash or cash equivalent is held in a qualified escrow account or in a qualified trust.⁴

A qualified escrow account has two elements. The escrow holder is not the taxpayer or a disqualified person, and the escrow agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent as provided in paragraph (g)(6).⁵

A qualified trust has the same two elements with one adjustment. The trustee must not be the taxpayer or a disqualified person, except that the relationship between the taxpayer and the trustee created by the qualified trust itself is not treated as a section 267(b) relationship for this purpose.⁶ Without that carve-out the trust would disqualify its own trustee, and the harbor would be empty.

The harbor ceases to apply at the time the taxpayer has an immediate ability or unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of the funds. Rights conferred upon the taxpayer under State law to terminate or dismiss the escrow holder or the trustee are disregarded for this purpose.⁷ That disregard is necessary and easily overlooked: a taxpayer who could terminate the escrow holder would, without it, arguably control the funds by controlling their custodian.

A taxpayer may receive money or other property directly from a party to the exchange without affecting the harbor, but not from the qualified escrow account or the qualified trust.⁸ The source of the payment is what matters. A closing adjustment paid by the buyer at the table is permissible. The same amount released from escrow is not.

The drafting trap in this harbor is stated by the regulation in a negative example, and it is worth quoting the structure of the point because the error is common. Where an escrow agreement expressly limited the intermediary's rights to receive, pledge, borrow, or otherwise obtain the benefits of the escrowed funds, but did not expressly limit the taxpayer's rights, the account would not have been a qualified escrow account, and the harbor would not have applied.⁹

The limitation must run against the taxpayer. Restricting the custodian instead is a natural instinct, because the custodian is the one holding the money, and it accomplishes nothing under this paragraph.

27.3 The qualified intermediary

The third harbor is the one on which the modern industry rests, and it solves a different problem from the first two. Its subject is agency rather than security.

Where a taxpayer's transfer of relinquished property involves a qualified intermediary, the intermediary is not considered the agent of the taxpayer for purposes of section 1031(a). The taxpayer's transfer of relinquished property and subsequent receipt of like-kind replacement property is treated as an exchange, and the constructive receipt determination is made as if the intermediary is not the taxpayer's agent.¹⁰

That formulation is the whole point. Absent the harbor, money held by an agent is money held for the principal, and the taxpayer would be in constructive receipt the moment the relinquished property closed. The regulation does not argue that the intermediary is not an agent. It directs that the determination be made as if it were not, and the regulation's own example says so in terms, reaching its result "regardless of whether C was B's agent under state law."¹¹

The harbor applies only if the agreement between the taxpayer and the qualified intermediary expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the intermediary as provided in paragraph (g)(6).¹²

A qualified intermediary is a person who is not the taxpayer or a disqualified person, and who enters into a written agreement with the taxpayer, the exchange agreement, and, as required by that agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.¹³ The provisions that permit those four acts to be accomplished by assignment and direct deeding are examined at 24.3 and 24.4.

Two observations about what the definition does not contain.

It imposes no qualification of any kind on the intermediary beyond not being the taxpayer and not being disqualified. There is no federal licensing requirement, no minimum capital, no bonding requirement, no insurance requirement, and no requirement that exchange funds be segregated from the intermediary's own assets or from those of other clients. A qualified intermediary in the federal tax sense may be a company formed the week before with no assets. The custodial consequences of that silence, the insolvencies it permitted, and the State regimes that responded to it are the subject of 55.1 through 55.4, and the point belongs in every engagement letter.

It also imposes no requirement that the intermediary be independent in any sense other than the disqualified person rules of Chapter 28 supply. Those rules do a great deal of work precisely because nothing else does.

27.4 Interest and growth factors

The fourth harbor permits the taxpayer to be compensated for the time value of money held during the exchange. The constructive receipt determination is made without regard to the fact that the taxpayer is or may be entitled to receive any interest or growth factor with respect to the deferred exchange, but only if the agreement pursuant to which the taxpayer is or may be entitled to it expressly limits the taxpayer's rights to receive it as provided in paragraph (g)(6).¹⁴

The taxpayer is treated as entitled to interest or a growth factor if the amount of money or property the taxpayer is entitled to receive depends upon the length of time elapsed between transfer of the relinquished property and receipt of the replacement property.¹⁵ The definition is functional and reaches arrangements that avoid the word interest.

Whatever it is called, it is interest. If the taxpayer receives interest or a growth factor as part of a deferred exchange, it is treated as interest regardless of whether it is paid in cash or in property, including property of a like kind, and the taxpayer must include it in income according to the taxpayer's method of accounting.¹⁶

Two consequences follow immediately. Growth paid in the form of additional replacement property is still interest income, not additional nonrecognition. And a taxpayer who defers gain on the exchange still reports the interest currently.

Who is taxed on the exchange funds. The regulation on this question is separate, is under section 468B(g), and is not widely understood.¹⁷ The default rule is that exchange funds are treated as loaned from the taxpayer to the exchange facilitator, an exchange facilitator loan, and the facilitator must take into account all items of income, deduction, and credit attributable to the exchange funds.¹⁸

That default is displaced where, in accordance with the escrow agreement, trust agreement, or exchange agreement, all the earnings attributable to the taxpayer's exchange funds are paid to the taxpayer.¹⁹ Whether the earnings attributable to the taxpayer are measured by an account or by allocation depends on how the funds are held. Where the facilitator holds all of the taxpayer's exchange funds in a separately identified account, generally an account established under the taxpayer's name and taxpayer identification number with a depository institution, the earnings credited to that account are deemed to be all the earnings attributable to the taxpayer's funds. A sub-account qualifies if the depository institution identifies it by the taxpayer's name and identification number and specifically credits earnings to it. Where the facilitator commingles the funds, an allocation is required.²⁰

A threshold worth knowing. An exchange facilitator loan is exempt from section 7872 if the amount of the exchange funds treated as loaned does not exceed $2,000,000 and the duration of the loan is six months or less.²¹ The duration condition is satisfied by most exchanges as a matter of arithmetic, since the exchange period cannot exceed one hundred eighty days. The dollar threshold is the one that binds, and it makes the below-market loan question a live one in larger transactions where the facilitator retains the float.

The practical counsel is simple and rarely followed. The float is the principal economics of the intermediary business, and who reports the earnings is determined by the documents rather than by expectation. Counsel should read the exchange agreement to see whether earnings are credited to the client, and should tell the client the answer before closing rather than when a Form 1099 arrives that does not match what anyone assumed.

27.5 Combining safe harbors

More than one safe harbor can be used in the same deferred exchange, but the terms and conditions of each must be separately satisfied.²²

The ordinary exchange uses at least two, and understanding why is the point of this section. The intermediary harbor of 27.3 answers the agency question, which is whether the person holding the money holds it for the taxpayer. The escrow or trust harbor of 27.2 answers the security question, which is whether cash securing the transferee's obligation puts the taxpayer in receipt. Neither answers the other, and a structure that satisfies one has not thereby satisfied the second.

The consequence for drafting is that the express limitation of 27.6 must appear in each agreement on which a harbor is claimed. It must be in the exchange agreement with the intermediary. If funds sit in an escrow, it must be in the escrow agreement as well. If the taxpayer is entitled to a growth factor, the agreement conferring that entitlement must limit the right to receive it. Incorporation by reference across documents is not what the regulation asks for, and the cost of stating the limitation four times is nothing.

A definitional provision makes the combination work and is easy to miss. For purposes of the safe harbor rules, the term taxpayer does not include a person or entity utilized in a safe harbor, and the regulation gives the qualified intermediary as its example.²³ That is what permits an intermediary to place exchange funds in a qualified escrow account. Were the intermediary treated as the taxpayer, the escrow holder would be holding funds for the taxpayer and the account could not qualify.

The same provision has a negative edge, and it is the trap already noted at 27.2. Because the intermediary is not the taxpayer, limiting the intermediary's rights in the escrow agreement does not satisfy the requirement that the taxpayer's rights be limited. The regulation's example turns on exactly that distinction.²⁴

The workable discipline is a document-by-document check performed before the relinquished property closes. For each agreement in the structure: does it contain the express limitation, does it name the correct restricted party, and does the person holding funds under it fail the disqualified person test of Chapter 28.

27.6 Permissible taxpayer access to funds

Three of the four harbors are conditioned on an express limitation of the taxpayer's rights, and paragraph (g)(6) states what that limitation must say. It is the most consequential drafting provision in the regulation and the one clients most often want to negotiate.

An agreement limits the taxpayer's rights only if it provides that the taxpayer has no rights, except as provided below, to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period.²⁵

The default is therefore total. Not merely no right to withdraw, but no right to pledge, to borrow against, or otherwise to obtain the benefits of the funds, for the full period. Two exceptions are permitted, and they are the only two.

The taxpayer who identified nothing. The agreement may provide that if the taxpayer has not identified replacement property by the end of the identification period, the taxpayer may have rights to receive, pledge, borrow, or otherwise obtain the benefits of the money at any time after the end of the identification period.²⁶ This is the day forty-six release, and it is available only to a taxpayer who identified nothing at all.

The taxpayer who identified. If the taxpayer has identified replacement property, the agreement may provide that rights arise upon or after either of two events.²⁷

The first is the receipt by the taxpayer of all of the replacement property to which the taxpayer is entitled under the exchange agreement. This is the ordinary completion case, and it is why residual funds are released at the final closing rather than earlier.

The second is the occurrence, after the end of the identification period, of a material and substantial contingency that relates to the deferred exchange, is provided for in writing, and 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.

Every element of that second exception is a condition, and each defeats a common expectation. The contingency must occur after the identification period, so a failure on day thirty does not open the door. It must have been provided for in writing, which means in advance and in the documents, not identified after it happens. It must be beyond the taxpayer's control, so a change of mind is not a contingency. And it must be material and substantial.

The structural consequence deserves to be stated plainly to every client before day forty-five, because it is counterintuitive and it is where the regulation bites hardest. A taxpayer who identifies replacement property and then decides not to proceed cannot obtain the funds until the end of the exchange period, which may be one hundred eighty days away, unless a written contingency of the required kind occurs. A taxpayer who identifies nothing gets the money on day forty-six. Identifying is therefore not a costless act of preserving optionality. It is a decision to leave the proceeds with a third party for up to another one hundred thirty-five days.

Items that are disregarded. A separate paragraph prevents the limitation from being defeated by ordinary commercial mechanics. In determining whether a harbor has ceased to apply and whether the taxpayer's rights are expressly limited, the taxpayer's receipt of or right to receive three categories of items is disregarded.²⁸

The first is items that a seller may receive as a consequence of the disposition of property and that are not included in the amount realized from the disposition, and the regulation gives prorated rents as its example.

The second is transactional items that relate to the disposition of the relinquished property or to the acquisition of the replacement property and that appear under local standards in the typical closing statements as the responsibility of a buyer or seller, and the regulation names commissions, prorated taxes, recording or transfer taxes, and title company fees.

The third is personal property generally resulting in gain recognition under section 1031(b) that is incidental to real property acquired in an exchange, meaning personal property that in standard commercial transactions is typically transferred together with the real property and whose aggregate fair market value does not exceed 15 percent of the aggregate fair market value of the replacement real property received.²⁹

The placement of that third item controls its meaning, and it is widely misread. It sits in a paragraph about items disregarded in applying the safe harbors. It protects the intermediary arrangement from being contaminated by the fact that a refrigerator came with the building. It does not make the refrigerator like-kind property. The regulation says so on its face by describing the property as generally resulting in gain recognition under section 1031(b). The personal property remains boot, and the consequences are quantified in Chapter 33. The point is developed at Chapter 17.

The counsel that closes this chapter is a matter of sequence rather than doctrine. Every one of these provisions must be in the documents before the relinquished property is transferred. There is no version of an exchange in which the limitation is added later, and the harbors are the only thing standing between the taxpayer and the rule stated in 24.1.