A 1031 exchange is much different than a straight sale or other type of real estate transaction. As such, it’s important for exchangors to inform all parties involved that the pending transaction will be part of a 1031 exchange because there are some extra steps both parties must take to ensure the exchange complies with Internal Revenue Service regulations.
In a straight sale of an investment property, the title is conveyed directly from the seller to the buyer, who puts up the funds to pay for the property at the closing table. In an exchange, though, there must be a third party involved throughout the entire transaction process in order to provide safe harbor for the exchangor.
In this article we’ll take a look at 1031 exchange cooperation clauses and why they are an important part of your exchange documentation.
Why It’s Important to Include a 1031 Exchange Cooperation Clause in Your Contracts
In order to successfully complete a 1031 exchange, exchangors must adhere to many IRS rules and regulations. Many of those stipulations involve the other party in the sale or purchase transaction.
By including 1031 exchange cooperation clauses in your purchase or sales agreement, you are informing the other party that the sale or purchase you intend to complete is part of a 1031 exchange. The language lets the other party know what’s expected of them and the role they need to play as the transaction moves through its various stages and into completion.
The 1031 exchange clause basically explains that the other party will be required to sign some additional documentation in order to facilitate the exchange. The language should inform the other party that there’s no additional cost or liability to them. The clause is merely a formality as well – it’s not a legally required element of either a 1031 exchange purchase or sale agreement.
The reason why this clause is extremely important, though, is because exchangors could be left on the hook for large capital gains tax bills if the second party refuses to cooperate with the conditions of the exchange. Any misstep during the exchange process, such as a missed deadline, could invalidate the exchange and result in a straight sale and generate a taxable event on any realized capital gains.
How a 1031 Exchange Clause Works
Perhaps the most important thing about a 1031 exchange is the use of a qualified intermediary throughout the sale and purchase transactions. The exchangor cannot touch any of the funds gained from the sale of a relinquished asset – they must instead be handled by a third-party exchange accommodator, also known as a qualified intermediary. Likewise, the exchangor cannot directly purchase a replacement asset – the QI is the actual seller of the relinquished asset and also the buyer of the replacement property in a 1031 exchange.
In order for all this to work, both the sale and purchase agreements must be assignable to the exchange accommodator. Including a 1031 exchange clause in these contracts establishes the taxpayer’s intent to perform a 1031 exchange with the properties, as well as creates the language necessary to assign the contracts to the qualified intermediary.
Here are two examples of 1031 exchange clauses. The actual language will vary depending on which 1031 concierge service or exchange platform you are working with:
- 1031 Exchange Clause for Relinquished Property
“Buyer is aware that the seller intends to perform a 1031 exchange. The seller requests buyer’s cooperation in this exchange and agrees to hold buyer harmless from any and all claims, costs, liabilities, or delays resulting from this exchange. Buyer agrees to an assignment of this contract to a qualified intermediary.”
- 1031 Exchange Clause for Relinquished Property
"Seller is informed that the buyer intends to acquire the property as part of a 1031 exchange. Seller agrees to cooperate in this exchange provided there is no delay in the closing or any additional expense borne by the seller. Seller agrees to the assignment of this contract to a Qualified Intermediary."
Putting it all Together
Although it’s not legally required, including a 1031 exchange clause in your purchase and sales agreements establishes your intent to complete a tax-deferred exchange, as well as notifies the other parties involved in these transactions that these agreements will be assigned to an exchange accommodator.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.