Safe Harbor

Under the 1991 Treasury Regulations, taxpayers who are exchanging business or investment property can transfer relinquished property, acquire replacement property, and get the same tax treatment as if they had swapped properties with another person.

The taxpayer has 45 days from the date that relinquished property is transferred (when the closing occurs), in which to identify potential replacement properties. The taxpayer has a total of 180 days from that same date to acquire (take title) to all replacement property. These are called the Identification Period and the Exchange Period, respectively. Also note that the Exchange Period must end no later than the tax return due date for the tax year in which the exchange began. Exchanges started late in the tax year may have a shortened Exchange Period unless the taxpayer applies for an extension of the tax return due date.

The exchanging taxpayer is not allowed to hold or have access to the proceeds of the relinquished property sale while the exchange is being executed (between the date relinquished property is transferred to the buyer and the taxpayer takes title to all replacement property). The Regulations specify alternative methods of safeguarding against possession of the cash by the taxpayer. These alternatives are Safe Harbors. The most common Safe Harbors used are a Qualified Intermediary and a Qualified Escrow Holder. These are third parties, unrelated to the taxpayer by family or business ties, who facilitate the exchange and hold the taxpayer's sales proceeds.

It is the role of the Qualified Intermediary to dispose of the taxpayer's relinquished property and acquire new replacement property for the taxpayer. The Qualified Escrow Holder keeps the cash proceeds from the taxpayer's access and disburses funds only for authorized purposes. And the Qualified Intermediary and Qualified Escrow Holder can be the same person or entity.

Usually, the Qualified Intermediary provides all exchange documentation, the IRS-mandated paperwork that turns a taxable sale into a tax-deferred exchange, and should be relied on to coordinate the execution of the exchange in compliance with the Internal Revenue Code and Regulations.

Because the purpose of the Intermediary is to act as the taxpayer's accommodator and the role of the Escrow Holder is to keep the taxpayer from having actual or constructive receipt of the sales proceeds, certain persons are specifically restricted from acting as the taxpayer's Safe Harbors. Those persons include anyone who is related to the taxpayer, is the employee or agent of the taxpayer or is related to an employee or agent of the taxpayer. Also excluded are the taxpayer's attorney, accountant, real estate agent or broker, or investment banker or broker, if non-exchange services have been provided within the two years prior to the exchange.

That is the definition of "qualified" under the Regulations. A Safe Harbor must also be qualified in the sense that he or she is honest and competent in handling the taxpayer's exchange transaction. Taxpayers contemplating a tax-deferred exchange should assure themselves that their Qualified Intermediary or Qualified Escrow Holder is experienced in tax-deferred exchanging and has an impeccable reputation for expertise and honesty.