Quick guide to 1031 Exchange Documentation :
Key elements of Contracts and Agreements
Written By Diane Schaefer, CES™ and President of Exchange Solutions, Inc., N.Y.
The rationale of an exchange is the transfer of property for property with one common party, whether it is investment or business use real property, or tangible or intangible personal property. Unlike a sale, where the seller transfers property for cash, to establish an exchange the taxpayer must document their intent to accomplish a legal IRC §1031 and execute other key documentation.
The minimum documentation, required by law, is as follows:
The taxpayer’s intention should be disclosed in the contract of sale (purchase and sale agreement) by adding simple language stating the reservation of an exchange transaction. If not in the original contract of sale, one can attach an addendum and deliver proper notice to the purchaser.
Secondly, and most important, is the exchange agreement. A written agreement should be drawn between the taxpayer and qualified intermediary (QI). The agreement between the two parties should be dated on or before the date of closing of the relinquished property, otherwise, it is not a valid exchange. Key elements of an exchange agreement are as follows:
1. The taxpayer’s intention of the exchange under IRC §1031 should be evident in the exchange agreement as well as the contract of sale;
2. The agreement should state that the QI will acquire the relinquished property from the taxpayer, transfer it to the purchaser, then acquire the replacement property from the seller and transfer it to the taxpayer completing the exchange. Written notice must be given to the purchaser of the relinquished property and the seller of the replacement property, respectively. The QI directly receives the funds from the transfer and utilizes the funds to acquire the replacement property (safe harbor 3);
3. Limitations on receiving exchange funds contained in Treasury Regulations Sections 1.1031(k)1(g)(6), “the (g)(6) limitations” is required so as not to result in constructive or actual receipt of the exchange proceeds (safe harbor 2);
4. The limitations on receiving the exchange funds should be secured or guaranteed for the benefit of both the taxpayer and the QI (Safe Harbor 1);
5. Interest and/or growth factors on the exchange funds should be defined in the agreement. If the taxpayer is to receive any interest on the exchange funds, this growth factor is limited, as well under, “the (g)(6) limitations;”
6. Definitions of the exchange periods should be provided; such as the identification period and the full term exchange period, Section 1.1031(k)-1(b)(2) (safe harbor 4);
7. The QI’s purpose to handle the exchange for a fee should be apparent.
An assignment and proper notice is also required for a valid exchange. Since Treasury Regulations Sections 1.1031(k)-1(g)(4)(iv) allows for direct deeding, an assignment of incidence of ownership is required by the QI of the exchange properties with proper notice of such assignment given to the purchaser of the relinquished property and the seller of the replacement property, respectively. It is treated that the QI has entered into the contract of the taxpayer’s relinquished and replacement properties and is in no capacity an agent for the taxpayer (safe harbor 3).
Similar to a sale transaction, basic conveyance documents are a necessity as well. A contract of sale/purchase and sale agreement is required to explicitly show the details of the conveyance for each of the exchange properties. It is also the vehicle by which the taxpayer assigns his/her/its rights to the QI in order to effectuate the exchange. A deed, bill of sale, invoice and or license are required to solidify the transfer of the exchanged properties. A settlement statement is required to illustrate the correct amount of funds coming into the exchange as well as proof the funds are appropriately being utilized to acquire the replacement property.
Some or all of the safe harbors should be utilized in a QI’s exchange documents to avoid any scrutiny and/or doubt by the service that an exchange has been accomplished within the standards of the code.