Cooperation Clause For 1031 Exchange
To create a valid 1031 exchange, the taxpayer must assign his rights under the purchase and sale agreement to First
American Exchange. In addition, the taxpayer must provide written notice of that assignment to all parties to the contract,
and it is usually advisable to get the other parties to acknowledge they have received the notice. The assignment and
notice are required in connection with both the sale of the relinquished property and the purchase of the replacement
property.
In order to facilitate the assignment and notice, most tax advisors recommend adding language to the purchase and sale
agreement that the taxpayer’s rights are assignable to First American Exchange and that the other parties to the contract
will cooperate in the exchange.
First American Exchange does not require that you use any specific language in your contracts, but this article includes
some sample language that is often used. This language may not be appropriate for your particular situation, so you
should have your advisors review and revise it as necessary.
Sale of Relinquished Property
Buyer acknowledges that Seller intends to perform a tax-deferred exchange pursuant to Section 1031 of the Internal
Revenue Code. Buyer accordingly agrees to an assignment of the rights under this contract by the Seller to First American
Exchange Company, a qualified intermediary. Buyer agrees to cooperate in such exchange as long as it does not delay the
closing or cause additional expense to Buyer.
Purchase of Replacement Property
Seller acknowledges that Buyer intends to perform a tax-deferred exchange pursuant to Section 1031 of the Internal
Revenue Code. Seller accordingly agrees to an assignment of the rights under this contract by the Buyer to First American
Exchange Company, a qualified intermediary. Seller agrees to cooperate in such exchange as long as it does not delay the
closing or cause additional expense to Seller.
Just the Basics: Tax-Deferred Exchanges Under IRC § 1031
Knowing some basic rules behind Internal Revenue Code §1031 can help investors defer paying capital gain tax on property
dispositions, resulting in more money to invest in a property acquisition. Generally, any real property can be exchanged,
provided it is held “for productive use in a trade or business” or for “investment” and is exchanged for property of “like-kind”
that will also be held for one of these same purposes.
Exchange of Property
The first requirement of a 1031 exchange is that the transaction must be structured as an exchange, rather than as a sale
and purchase. In order to accomplish this, a qualified intermediary must be involved with the sale of the relinquished
property (property sold) and acquisition of the replacement property (property acquired). To ensure that the transaction is
considered an exchange, rather than a sale followed by a purchase, the investor must sign an exchange agreement,
assignment of the purchase contract, as well as other documentation before the relinquished property sells, and the
intermediary must hold the proceeds until they are used to buy the replacement property. As long as the appropriate
documentation is signed, the intermediary does not need to take title to the property.
Like-Kind Requirement
The replacement property must be considered “like-kind” to the relinquished property. The like-kind requirement is fairly
broad for real property exchanges. For example, an office building can be exchanged for vacant land, an apartment building
can be exchanged for a single family rental home, or a duplex can be exchanged for a retail strip center; basically any real
property held for investment qualifies as “like-kind.”
Same Taxpayer Rule
In order to qualify for tax deferral treatment, the same taxpayer selling the relinquished property must purchase the
replacement property. For example, if Company B sells the relinquished property, Company B must also acquire the
replacement property. An exception to this requirement is entities that are considered disregarded for tax purposes, such as
single member limited liability companies and revocable trusts. For example, Sue Smith may own a commercial building in
her own name. She can sell that property and acquire replacement property in her own name, or she may take title in the
name of a limited liability company in which she is the sole member, or she may create a revocable trust and take title in the
name of the trust. In each case, Sue Smith is still considered the same taxpayer thus allowing her to complete an exchange.
Can I Exchange My Vacation Home?
A common 1031 question is: I have a vacation home in Hawaii and I go there every year for two weeks. I also rent the
property from time to time. Can I consider that property as investment property and trade it in a 1031 exchange? In 2008,
the IRS published a ruling which creates a guideline for taxpayers wanting to exchange their vacation homes.
When does a vacation home qualify as investment property?
In order to complete a 1031 exchange, both the relinquished and replacement properties must be held for investment
purposes or for use in the taxpayer’s trade or business. Property that is held for personal use cannot be traded in a 1031
exchange.
Some taxpayers have argued that owning property with the expectation of gain from appreciation should be sufficient to
qualify a home as investment property even if it is not rented. In a 2007 court case, the court held that, in order for property
to be considered to be investment property for 1031 purposes, it must be held primarily for investment purposes. If it is
held primarily for personal use, it is not investment property even if the owners also expect to enjoy a profit when the house
is sold.
Even if the taxpayer rents the vacation home in addition to using it for personal use, it has been unclear how much the
property must be rented in order to be considered investment property, and how much personal use is acceptable. In
2008, the IRS issued Revenue Procedure 2008-16, clarifying some of these issues. The ruling establishes a safe harbor
which, if followed, guaranties that the IRS won’t challenge whether a second home qualifies as investment property.
The Safe Harbor: Revenue Procedure 2008-16
The guidelines set forth in the Revenue Procedure are as follows:
Relinquished Property:
Relinquished property must be owned by the investor for the 24 months immediately prior to the exchange. In each of the
two consecutive 12 month periods prior to the exchange, (1) the investor must rent the property for at least 14 days at fair
market value, and (2) the investor cannot use the property more than the greater of 14 days or 10% of the total number of
days during the 12 month period that the property is rented at fair market value.
The information shared in this blog was provided by Jeannie Burke of First American Exchange, who conducted the 1031 Exchange training.