Reverse and Improvement 1031 Exchanges Beyond the Safe Harbor: What Investors Should Know

While most 1031 Exchanges follow standard procedures, certain complex transactions — such as reverse exchanges and property improvement exchanges — sometimes fall outside the IRS “safe harbor” guidelines. These nontraditional arrangements can still qualify for tax deferral, but they carry added complexity and potential tax risk.

This article explains what it means to operate outside the safe harbor, why these structures exist, and how key court decisions have influenced their treatment under IRS rules.

Understanding the Safe Harbor Rules

In Revenue Procedure 2000-37, the IRS introduced a “safe harbor” for taxpayers completing reverse exchanges. This guidance allows investors to use an Exchange Accommodation Titleholder (EAT) to temporarily hold either the relinquished or replacement property, giving the exchanger up to 180 days to complete the transaction.

Under the safe harbor, if the structure follows specific procedural requirements — including timelines, documentation, and the use of a qualified EAT — the IRS will not challenge the transaction’s validity solely based on who holds title during the exchange period.

What Happens Outside the Safe Harbor

A reverse or improvement exchange outside the safe harbor occurs when one or more of the safe harbor’s conditions are not met. This might include:

• Holding the property longer than the 180-day limit,

• Having the exchanger (not the EAT) bear too much economic risk, or

• Entering into arrangements that blur ownership control during the parking period.

While these transactions are not automatically disqualified, they are subject to greater IRS scrutiny. The key question becomes: Who truly owns the property during the exchange period — the taxpayer or the accommodation party?

The Bartell Case: A Turning Point

A major development in this area came from the Estate of George H. Bartell, Jr. v. Commissioner (2016).

In this case, the taxpayer arranged for improvements to be made on the replacement property before the old property was sold, with title held by another entity. Even though the structure did not meet the requirements of Revenue Procedure 2000-37, the Ninth Circuit Court of Appeals upheld the exchange, ruling that Bartell’s arrangement could still qualify under Section 1031 because he did not technically take ownership until after his relinquished property was sold.

The Bartell decision signaled that safe harbor compliance is not the only path to a valid exchange, but also reaffirmed that each case depends heavily on facts, timing, and control.

Risks and Considerations for Non–Safe Harbor Transactions

When operating outside the safe harbor, the burden of proof shifts to the taxpayer. The IRS or courts will closely examine:

• Who bore the benefits and burdens of ownership,

• Whether the transaction had a clear exchange intent, and

• If the exchange was structured primarily for tax deferral rather than substance.

Because the standards are fact-specific, even small missteps in documentation, control, or timing can jeopardize deferral eligibility.

Why Professional Guidance Is Essential

Reverse and improvement exchanges beyond the safe harbor require careful legal and tax structuring. Working with experienced professionals — including a Qualified Intermediary (QI) and tax counsel familiar with Section 1031 — can help ensure compliance and minimize audit risk.

Investors should document every stage of the exchange and seek written guidance on ownership, improvements, and timing.

Balancing Flexibility and Compliance

Reverse and property improvement exchanges outside the safe harbor can still qualify under Section 1031, but they carry heightened risk and complexity. The Bartell case opened the door for flexibility, yet it also underscored the need for precise documentation and expert oversight. When in doubt, following the safe harbor remains the most secure route for ensuring tax-deferral benefits under the IRS’s 1031 Exchange rules.

Disclaimer
This article is for informational purposes only and should not be construed as legal or tax advice. Always consult a Qualified Intermediary and tax advisor before structuring a reverse or improvement exchange, especially when operating outside the IRS safe harbor.