A 1031 exchange allows you to reinvest proceeds from the sale of investment real estate into another like-kind real estate property of equal or greater value. When performed correctly, the exchange can help you defer capital gains taxes and depreciation capture on the sale.
Part of that proper performance involves using the correct contractual language. You'll likely use standard sales and purchase contracts when selling your relinquished asset and buying the replacement property. Adding 1031 exchange contingencies to these documents can avoid complications and costly mistakes down the road.
Additional language added to like-kind sales and purchase agreements might include the following.
Clear Intent
Clear intent means you specifically state that you plan to defer capital gains taxes by reinvesting proceeds from your property’s sale into a like-kind property. Clear intent also signals that all parties involved will perform the transactions under 1031 exchange guidelines and rules.
Cooperation Clause
A cooperation clause in a contract legally obligates you and other buyers and sellers involved in the process to collaborate in conducting a 1031 exchange. The language should ensure that the process is as seamless as possible and that it follows the necessary regulations (including timelines and the use of a Qualified Intermediary). While this clause does not legally obligate parties to complete the exchange, it ensures smoother execution.
Legal and Financial Protections
You should also include language that holds you and other parties legally and financially harmless from unexpected costs, delays, or liabilities that could be associated with the like-kind exchange. This can protect you while reassuring other parties that they won’t have to deal with potential legal challenges or unexpected expenses with the exchange process.
Rights Assignments to the Qualified Intermediary
A Qualified Intermediary (QI) is a necessity with a valid 1031 exchange. The purchase and sales contract should include information about the QI’s role in the exchange. As the exchanger, you must assign certain rights to this entity purchase and sales agreement. Failure to do this means the exchange won’t follow the IRS guidelines and could be voided.
When the assignment is made, the QI is listed as the Seller on a Settlement Statement or as the Buyer when dealing with the replacement property.
The Importance of Contingency Add-Ons
Adding appropriate language to sales and purchase agreements when conducting a like-kind exchange can help ensure that everyone is on the same page and understands the rules and regulations involved with the process. Providing intent, identifying a QI, using a cooperation clause, and other statements can help a smooth exchange.
If you are using a 1031 exchange to defer tax payments, consult with a qualified attorney and other qualified professionals to ensure that the appropriate language is added.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
