1031 Tax Deferred Exchange Contract Language
It refers to contractual language used in real estate when a taxpayer wishes to sell one property and buy another for investment purposes.3 min read
Updated November 25, 2020:
1031 Tax-Deferred Exchange Contract Language refers to the contractual language used in real estate when a taxpayer wishes to sell one property and buy another for investment purposes.
When it comes to real estate investments, the Internal Revenue Code requires specific language in both purchase and sale agreements establishing an investor's intent to perform an exchange. This language specifies that an investor intends to sell their investment property and purchase a new one for investment purposes. For such an exchange to occur, the contract must express the intention. This is necessary in order for the exchange to qualify for the IRS. Not only does this verbiage establish the investor's intent, but it enables firms, like Exchange Resource, to associate with the sale and purchase contracts.
The specific contractual language related to this intention allows a company to complete all tasks necessary for finalizing the exchange. Also, the language provides advance notification to the other party that the contract will need to be assigned to an intermediary.
Section 1031 Exchanges
While many taxpayers include phrases within their purchase and sale contracts to establish their intent to exchange, the Internal Revenue Code does not require this in a Section 1031 tax-deferred exchange. The motive behind selling and purchasing property is what makes a Section 1031 exchange different than other real estate transactions. Taxpayers and real estate investment professionals may add a Section 1031 exchange clause to the agreements for several reasons, including:
- Establishing their intent to complete an IRC Section 1031 tax-deferred exchange.
- Notifying the other party of the intent to assign the purchase or sale contract to a qualified intermediary.
For a Section 1031 exchange, it is imperative that the purchase and sale contracts for both parties be assignable. To arrange a regular exchange transaction that involves direct deeding, the qualified intermediary needs to be assigned into a contract as the buyer of the new property and seller of the relinquished property. The taxpayer must examine their agreements to make sure they are not prohibited from transferring their buyer/seller positions to a qualified intermediary.
In a normal delayed exchange associated with direct deeding and structured by a qualified intermediary, the closing settlement statement will show the qualified intermediary as the seller instead of the taxpayer. The contractual language shows that there are no issues regarding either the purchase or sale of the property.
Section 1031 Exchange Clauses
Some typical language used within Section 1031 tax-deferred exchanges include:
- Sale of Relinquished Property: “Buyer is aware that seller intends to perform an IRC Section 1031 tax-deferred exchange. Seller requests buyer's cooperation in such an exchange and agrees to hold buyer harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Buyer agrees to an assignment of this contract to a qualified intermediary by the seller.”
- Purchase of Replacement Property: “Seller is aware that buyer intends to perform an IRC Section 1031 tax-deferred exchange. Buyer requests seller's cooperation in such an exchange and agrees to hold Seller harmless from any and all claims, costs, liabilities, or delays in time resulting from such an exchange. Seller agrees to an assignment of this purchase and sale agreement to a qualified intermediary by the buyer.”
Adding Section 1031 Language to Sale and Purchase Contracts
The real estate agents who are associated with both the new and relinquished properties are responsible for adding Section 1031 language into the sale and purchase contracts. If the language is not included in the original contracts, the assigned agent may add the language once they become involved in escrow. As another option, all involved parties may sign an IRS form instead of adding the language directly into the contracts.
Shortly before closing, it's still possible to turn an otherwise taxable sale into a Section 1031 exchange. If the taxpayer wishes to set up an exchange right before closing, they must immediately contact a qualified intermediary to prepare the necessary exchange documents. Such preparation will usually include written notice of the assignment of both the purchase and sale agreements and the forwarding of exchange documents to the appropriate entities (typically the closing officer) before the sale closes on the relinquished property.
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