Entering a 1031 exchange is a good strategy that can help you preserve your capital while diversifying your investment portfolio. If you follow the rules set by the IRS, you can enjoy tax-deferral benefits that let you delay payments for capital gains taxes. There are, however, many 1013 exchange rules, including the proper contract language for the sale and purchase agreements.
What kind of language should be included in a 1031 exchange contract? What are the specific clauses or information that you must take into account to ensure full compliance? Realized 1031 has shared an informative guide to answering these questions. Keep reading to learn more.
Refresher on Key Like-kind Exchange Rules
As outlined in Section 1031 of the Revenue Code, investors must follow the below key rules to maintain their tax-deferred status.
- Like-kind Property: The relinquished and replacement property must be of the same nature or character. More specifically, the assets must be used for investment or business purposes.
- Presence of a Qualified Intermediary: You cannot take direct control of the proceeds. As such, a neutral third party — the qualified intermediary — must handle the exchange process and hold the proceeds from the sale.
- 180-day Timeframe: The entire transaction must take place within 180 days, with the first 45 days dedicated to identifying replacement properties.
- Proper Assignment of Rights: The contract must allow assignment to the qualified intermediary, ensuring that you do not take actual or constructive receipt of the proceeds.
- Buyer and Seller Cooperation: Both parties must acknowledge and agree to facilitate the exchange in their contracts.
This is just a brief summary of these key rules as background for this article. Meeting these requirements means having certain specific language in the sales and purchase agreements.
Important Contract Language for the Sale Agreement
There are two main contracts involved in 1031 exchanges: the sale agreement and the purchase agreement. When selling the relinquished property, the sale agreement comes into play. This is the document that outlines the terms and conditions under which the relinquished property is sold. For 1031 exchanges, the sale agreement will should include the following language.
Intent to Complete a 1031 Exchange
One of the most important inclusions in the sale agreement is the “Intent to Exchange” clause. It will have language that explicitly shares the seller’s intention to complete a tax-deferred 1031 exchange. This “Intent to Exchange” clause does not bind the other party to participate in the exchange but serves to make all parties aware that the sale is part of a 1031 exchange.
Cooperation Clause for the Buyer
Since a 1031 exchange involves strict timing and procedural requirements, it helps that the buyer acknowledges and agrees to accommodate the exchange. While the buyer is not legally required to participate, including this clause helps prevent potential roadblocks, such as delayed payments.
Assignment Clause
Given how the IRS prohibits direct control of the proceeds by the investor, the contract should have language that assigns their rights to the qualified intermediary. The clause ensures that the qualified intermediary holds the funds and facilitates the exchange in compliance with IRS regulations.
Important Contract Language for the Purchase Agreement
The second type of 1031 exchange contract is the purchase agreement, applicable upon acquiring the replacement property. Here are the clauses to include.
Intent to Acquire a Property for a 1031 Exchange
Similar to the first intent to complete clause, the intent to acquire clause of the purchase agreement states that the buyer is acquiring the property as part of a 1031 exchange. With this language, you can ensure all parties recognize the transaction’s tax-deferred nature.
Cooperation Clause
A cooperation clause requests that the other party — the seller, in this case — will not obstruct the exchange process. While the cooperating party is not required to assume any financial or legal responsibility, they must agree to sign the necessary documents to facilitate the transaction. For buyers like you, this clause is important to ensure that the seller won’t create situations that may delay the exchange, resulting in you losing the tax-deferred status.
Assignment Clause
This clause serves a similar purpose as the assignment clause of the sale agreement. The language states clearly the responsibility of the qualified intermediary, including their right to handle the funds before transferring them to the property seller.
Contingency Clause for 1031 Exchange
Because 1031 exchanges are time-sensitive, an exchange contingency clause can help protect the buyer if the exchange process is delayed or fails. This clause allows for contract termination under specific conditions.
Common Mistakes and How To Avoid Them
Given the critical importance of contracts in 1031 exchanges, it’s important to be vigilant of common pitfalls and avoid making these mistakes. Here are a few things you should keep in mind.
- No Mention of Intent: Selling or buying a property within a 1031 exchange isn’t like traditional real estate transactions. Making your intent explicit is important to ensure that the IRS will recognize the exchange as tax-deferred.
- No Assignment Clause: Without a clause allowing the contract to be assigned to a qualified intermediary, the IRS may assume that you received the funds directly, triggering capital gains tax.
- Not Working With Tax Professionals: Given the complexity of 1031 exchange contracts, it’s best to engage with tax attorneys or accountants who can help you draft ironclad contracts. Failing to do so makes you more prone to mistakes that may jeopardize your tax-deferred status.
Wrapping Up: Language in 1031 Exchange Contracts
When it comes to like-kind exchange contracts, the 1031 exchange language is crucial. Including certain clauses like the intent and assignment clauses helps ensure that you’re not only following IRS rules but are also protected. With these added provisions, you establish clear expectations, minimize risks, and ensure a smoother, more successful 1031 exchange. For guidance regarding the specific language to include, we’re here to help. Reach out to Realized 1031 today to learn more.
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.
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