For those involved with 1031 exchanges,“safe harbor” is among the more significant terms in Section 1031 tax law.
One of the surest ways accountants can contribute to their credibility is to offer basic guidance on safe harbor exchanges.
The reason why this will contribute a great deal to an accountant’s credibility is because this concept touches directly on the risk level of 1031 exchanges. What’s more, this concept requires firm knowledge of the technical material underlying exchanges; offering good guidance isn’t something which can come from any source, in other words.
In this post, we will briefly clarify the different uses of this term and discuss why it is important for clients to understand clearly what this term means.
Non-Safe Harbor Refers to IRS Safe Harbors
The term “safe harbor” actually has two distinct meanings in the context of Section 1031. In order to determine which meaning is being used, it’s necessary to the refer to the wider context of the term in a given situation.
One meaning of this term refers to the protections provided by the Section (k) Treasury Regulations which pertain to receipt of exchange proceeds. The Treasury Regulations provide 4 “safe harbors” which insulate taxpayers from actual or constructive receipt.
Counseling clients on this meaning of the term safe harbor is useful, but less useful than counseling on the other meaning. The other meaning is used in the context of IRS guidance on the mechanics of 1031 exchanges.
The tax code only provides general rules for the mechanics of 1031 exchanges; this is why the IRS offers guidelines for certain mechanics. The IRS provides various safe harbors in order to avoid the costly litigation which would follow from a legal challenge.
The most widely cited IRS safe harbor is the one provided by Revenue Procedure 2000-37. This document provides a safe harbor for reverse 1031 exchanges. If taxpayers follow the guidelines presented by this document, the IRS won’t challenge the validity of the exchange (at least not on the grounds covered by the safe harbor).
Importantly, this doesn’t mean that a given transaction is “legal” in the sense that it has been ruled as such by a court. It only means that the transaction won’t be challenged on the grounds covered by the safe harbor. The interest being furthered is cost efficiency, not legalistic accuracy.
When discussing this topic with a client, the key thing is to have the client understand that the safe harbor is a tool which the IRS has created to facilitate exchanges.
Non-Safe Harbors May Require Advanced Risk Counseling
This second meaning is critical because reverse 1031 exchanges are very common. And, depending on the circumstances, a given client may be curious as to whether the safe harbor needs to be obtained.
This issue has come up in recent years because of the ruling in the well-known Bartell case. In that case, a reverse exchange which went beyond the time limits imposed by Rev. Proc. 2000-37 was upheld and determined to be a legitimate exchange.
The court, therefore, upheld a “non-safe harbor” exchange. This ruling may have been influenced in part by the fact that the Bartell transaction was initiated before Rev. Proc. 2000-37.
However, the important thing to understand here is that Bartell is where we need to ultimately look to structure exchanges. This is true even if Bartell directly conflicts with Rev. Proc. 2000-37. Congress may step in and change the tax code to create firm rules for reverse exchanges. But, until that time, the Bartell case should be seen as an authoritative source.
Clients need to understand that non-safe harbor exchanges carry unique risks, and even talented tax attorneys can only provide so much value in this area. A talented tax attorney can review the existing law and make an independent determination after considering the specific facts of a given client’s transaction. But even then, the client needs to know that there are always risks when a safe harbor isn’t abided.
There’s the risk that the client’s fact pattern may be different enough to warrant a new ruling. As the Bartell case shows, the law of Section 1031 is still evolving, and so a given client may be able to execute a non-safe harbor exchange which is held to be perfectly legitimate. But there’s always a risk that the Court may determine that the client’s transaction failed to stay within the meaning of an exchange as conceived by Section 1031.