Real estate investors who have the ability to keep investment capital in an illiquid state often complete 1031 exchanges in order to defer capital gains taxes on the sale of real property assets.
The practice has become so common that many standard real estate purchase agreements come with a checkbox indicating the purchase is intended to satisfy the “like-kind” requirement of a 1031 exchange -- and that can throw off some sellers who are unfamiliar with the exchange process.
Don’t panic if you see the “1031 exchange sale condition” language in a contract. For starters, your legal counsel should be able to put your mind at ease about such language. But we are here as well to help you demystify any potential ambiguities.
What is a 1031 Exchange?
IRS Code Section 1031 states that property owners can sell an investment property and avoid having to immediately pay taxes on any capital gains above their investment and capital improvement basis so long as they purchase a “like-kind” replacement asset with the proceeds from the sale.
The 1031 exchange process can be quite complicated. There are two crucial deadlines investors must meet in order to successfully complete their exchanges:
- 45 days from close of sale on the relinquished asset to formally identify a replacement property
- 180 from the date of sale to close on the replacement asset.
These deadlines are inflexible, and missing one of these deadlines could result in a disqualified exchange. Investors who successfully complete 1031 exchanges can defer capital gains taxes generated from the sale of their original assets.
1031 Exchange Sale Condition
Another hard-and-fast rule about 1031 exchanges is that the exchanger cannot take possession of any funds generated from the sale -- they must be held by a Qualified Intermediary throughout the exchange process.
Which brings us back to the language of “1031 exchange sale condition.” This contractual language is merely an alert to sellers that the prospective buyer intends to purchase the asset in order to complete a 1031 exchange.
This language (and the exchange process as a whole), has no bearing on the sale of a commercial investment property between seller and exchanger. Rather, it’s a notice to the seller that a Qualified Intermediary will be stepping in during the sale process to facilitate and complete the 1031 exchange. There are no impacts upon buyers or sellers.
However, the language is important because the QI is the actual buyer of the asset rather than the other party. The QI must be assigned into purchase or sale contracts in order to handle the important matters of titling, deeding, transfer, recording, and other key aspects associated with the transfer of real property from one entity to another.
The Bottom Line
Investors who purchase replacement assets in order to satisfy the requirements of 1031 exchanges must follow to the letter the stipulations set forth in IRS Code Section 1031. A primary tenet of those regulations is having a Qualified Intermediary hold proceeds from the sale of relinquished assets in escrow -- buyers can’t touch these funds under any circumstances during the exchange process.
Alerting sellers with the contractual language “1031 exchange sale condition” that their property is intended to satisfy a 1031 exchange has no bearing whatsoever on any aspect of the sale. It’s merely a way of informing sellers that a QI will be taking over the process of purchasing and closing on the asset. Regardless of your comfort level with interpreting the legal conditions of a purchase or sale contract, it’s still a good idea to engage legal counsel to make sure you are fully aware of all aspects of a pending deal.