For a transaction to satisfy the requirements of IRC Section 1031, the taxpayer must meet several provisions of the code. While the IRS does not require that the sale and purchase agreements contain language that establishes the owners' intent to complete an exchange, many participants include clarifying verbiage anyway. Often the purpose for the seller to insert this language in the agreement is twofold:
To declare intent to perform the tax-deferred exchange according to Section 1031.
To provide notice to the other party in the transaction that the contract will include the assignment to an intermediary.
The seller may also add that the buyer’s cooperation is requested and can choose to add language that will hold the buyer harmless from delays, claims, liabilities, or costs that result from the exchange. Either way, the buyer will want to insert similar language into the agreement for their protection.
The taxpayer needs to verify that the agreement for both the sale and purchase transactions are assignable so that the qualified intermediary's position is not in jeopardy. The intermediary must be assigned in both contracts (as the seller of the relinquished property and then as the buyer of the replacement property).
Suppose you are the non-taxpayer party in a 1031 exchange (the buyer of the relinquished property or the seller of the replacement asset). In that case, you are also interested in the contract language. You want to ensure that the agreement acknowledges that:
You are aware of the other party’s intention to complete the 1031 exchange.
You are aware that the buyer or seller has assigned certain rights within the transaction to the qualified intermediary.
You agree to cooperate as long as you do not incur any additional costs or liability.
The taxpayer and intermediary also need an agreement, which specifies that the intermediary will acquire the taxpayer's relinquished property, transfer it to the purchaser, then purchase the replacement property from the seller and transfer it to the taxpayer. The agreement between the taxpayer and thequalified intermediary (also known as a 1031 exchange accommodator) should also include provisions for avoiding the funds coming into actual or constructive receipt by the taxpayer. This agreement, which should be signed and dated on or before the closing date of the relinquished property sale, should establish that the intermediary is handling the exchange for remuneration.
While not part of the exchange agreement, the transaction documentation should also include conveyance documents. Deeds, bills of sale, and applicable invoices should be incorporated into the transaction records by the intermediary and reconciled with a settlement statement that documents the correct amount of funds coming into the exchange from the sale of the relinquished property and being used to acquire the replacement property.
Suppose a sale starts as an ordinary transaction, and then the taxpayer decides to convert it to a 1031 exchange. In that case, the taxpayer must ensure that all compliance requirements are met in the closing documents before the sale is final. If the funds from the sale inadvertently become available to the taxpayer, the exchange will not meet the requirements. Also, keep in mind that if the goal is to defer all of the capital gains from the sale, the replacement property must be of equal or greater value than the original property, or the difference will be taxable.
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