Typical 1031 Exchange Agreements
Section 1031 is one of the most financially beneficial provisions in the tax code. This section literally allows taxpayers to use borrowed tax money to purchase more investment or business property. With this borrowed tax money, taxpayers can make their own wealth grow faster. Although this may not have been the original intent of Sec. 1031, this is what it has grown to be. To conduct an exchange, a contract is created between the taxpayer and the facilitator (or “qualified intermediary”). This is true for all 1031 exchanges except direct swaps, because direct swaps don’t require a facilitator. This contract is known as a “1031 exchange agreement” in the industry. Every exchange agreement is unique, and this is because an exchange agreement is proprietary to each facilitator.
In this post, we will go over the basics of what should be included in a typical Sec. 1031 exchange agreement. Again, an actual exchange agreement will, no doubt, include additional terms which aren’t referenced here. But virtually all exchange agreements will (or should) include the provisions mentioned in this post.
1031 Exchange Agreement Required Elements
Exchange agreements have to include language which establishes the relationship between the taxpayer and facilitator. They also have to include assignability language, as well as language related to the receipt requirements of the Treasury Regulations. We’ll explore each of these items in more detail.
1031 Exchange Agreements vs. QEAA
First off, let’s make a quick differentiation between an “exchange agreement” and a “qualified exchange accommodation agreement,” or QEAA. A 1031 exchange agreement refers to a contract governing either a straightforward (delayed) exchange, or improvement exchanges which don’t involve an EAT. A QEAA, on the other hand, refers to a contract between a taxpayer and an EAT; a QEAA is necessary whenever there is a “parking arrangement.” A QEAA is a more specialized type of contract which contains language designed to comply with certain regulations and guidelines. Delayed exchanges are much more common than those which require a QEAA. Accordingly, exchange agreements are much more commonly encountered.
Assignability of the Contract
One of the key features of a standard exchange agreement is its assignability language. A typical exchange agreement will contain language which makes both the sales and purchase contracts “assignable” to the facilitator. This assignability language enables the facilitator to step in and “act” as the buyer and seller in the exchange process. When the facilitator acts in this way, direct deeding can take place, first between the taxpayer and the buyer, and then between the taxpayer and the seller. Direct deeding carries several benefits.
Cooperation Clause & Release of Liability
Another common feature of a standard exchange agreement is a “cooperation clause.” Most exchange agreements will include a clause which requests cooperation from buyers and sellers in the performance of the 1031 exchange. This serves to give notice of the 1031 exchange and establishes the intent of the taxpayer to perform the exchange. What’s more, providing this type of notice can be useful because it may elicit helpful behavior from either the buyer or seller.
Release of Liability
Most exchange agreements will also include language which releases any potential liability for damages from the other parties involved – i.e. the buyer and seller. This language is usually used in conjunction with the cooperation clause. Taxpayers want to have their exchange go as smoothly as possible; alerting the other parties, and assuring them that they have no potential for liability, can contribute toward this goal.
Compliance with Receipt Requirements
One other thing that most exchange agreements will contain is language pertaining to the receipt requirements of the Treasury Regulations. The Section (k) Treasury Regulations contain language pertaining to actual and constructive receipt of funds. The regulations also contain language which applies to how escrow accounts and trust accounts are handled if they’re used in the exchange. Most exchange agreements will contain specific language which makes it clear that the taxpayer will be in full compliance with these regulations. To be more precise, most agreements will state that the taxpayer does not have, and will not have, access to the funds.
Prevent Actual or Constructive Receipt
As we’ve discussed before, the principal function of the intermediary is to protect the taxpayer from receipt of funds. If the taxpayer is ever in either actual or constructive receipt of funds during the exchange period, then the transaction will fail. Hence, most exchange agreements will go the extra mile and contain specific language that documents that this regulation has been accounted for.
Each 1031 Exchange Agreement is Unique
This list isn’t meant to be exhaustive. As mentioned, contracts are proprietary documents of facilitators, and so every one will be unique. Some exchange agreements will list the bank account used to hold the taxpayer’s exchange proceeds, for instance. But most exchange agreements will address the areas referenced above. The more familiar you are with these documents, the better.
Contact MCC Today for Assistance!
At Mackay, Caswell & Callahan, P.C., we handle a range of tax and business cases. In addition to 1031 exchanges, we provide counsel related to IRS tax debt, voluntary disclosures, sales tax cases and so forth. We have a broad base of knowledge and experience from which to counsel clients. If you need assistance, don’t hesitate to give us a call. Reach out and one of our top New York City tax attorneys can review your issue right away.
Image credit: Creditscoregeek