In a 1031 exchange, the investor (“exchangor”) hires a Qualified Intermediary (QI) to act as a middleman and help make sure the process meets IRS requirements. To make this official, the exchanger must assign some rights in any purchase contract to the QI. This step is crucial for the QI to execute the 1031 exchange successfully.
The IRS also requires the exchangor to notify the other party involved in the transaction about the 1031 exchange. This notification can be done through various methods, each with its own set of benefits and considerations.
- One common approach to satisfy both requirements is to include a Cooperation Clause in the real estate contract. This clause obligates both parties to cooperate with the 1031 exchange requirements, ensuring everyone is on the same page from the outset.
- Alternatively, some investors prefer to notify the other party at closing to avoid potential complications during negotiations. This method involves providing a standalone document about the exchange, assuring the other party that they are not impacted by the process.
- Another crucial element is an Assignability Clause, which allows the assignment of contract rights to the QI. If a contract includes a No-Assignment clause, it must be removed to proceed with the exchange.
Below, we’ll explore these clauses, providing examples and discussing when and if they are necessary.
What is a Cooperation Clause?
A Cooperation Clause is an optional provision included in real estate contracts outlining the agreement of all parties to cooperate with the requirements of a 1031 exchange. Essentially, it obligates the buyer and seller to perform actions needed to comply with Section 1031 of the IRS’s tax code. This includes allowing the contract to be assigned to a Qualified Intermediary to step into the transaction on behalf of the exchangor so they are not touching the funds.
Below are a few examples of Cooperation Clauses typically used in 1031 Exchange transactions. Remember that every transaction is unique, so always consult your legal or tax advisor to ensure that this language and timing are right for each contract and situation.
Example of a Cooperation Clause in a Relinquished Sale Contract
A relinquished sale contract involves the sale of the property currently owned by the investor performing the 1031 exchange. Here’s an example of what a Cooperation Clause might look like in this context:
“Buyer agrees to cooperate with Seller to effectuate a tax-deferred exchange under Section 1031 of the Internal Revenue Code. Buyer’s cooperation shall include, but not be limited to, executing documents, instruments, and escrow instructions necessary to complete the exchange at no additional cost or liability to Buyer. Buyer acknowledges that Seller’s rights and obligations under this contract may be assigned to a Qualified Intermediary to facilitate the exchange.”
Example of a Cooperation Clause in a Replacement Purchase Contract
In a replacement purchase contract, the exchanging investor is acquiring a new property to complete their 1031 exchange. A Cooperation Clause might be worded as follows:
“Seller agrees to cooperate with Buyer to effectuate a tax-deferred exchange under Section 1031 of the Internal Revenue Code. Seller’s cooperation shall include, but not be limited to, executing documents, instruments, and escrow instructions necessary to complete the exchange at no additional cost or liability to Seller. Seller acknowledges that Buyer’s rights and obligations under this contract may be assigned to a Qualified Intermediary to facilitate the exchange.”
Should I Include a Cooperation Clause?
While Cooperation Clauses are customary, the IRS does not require them to complete a 1031 exchange. Instead,the IRS requires that the exchanging party notify the other party that they are performing a 1031 exchange at some point prior to the completion of the transaction.
This begs the following questions:
- When should I notify the other party about my 1031 exchange?
- How should I notify the other party about my 1031 exchange?
There are two ways an exchangor can approach this:
Add a Cooperation Clause in the Purchase Agreement
One effective strategy is to include a Cooperation Clause in your offer or purchase contract. This notifies the other party and secures their agreement to cooperate if they accept the contract.
Many advisors, real estate agents, and Qualified Intermediaries (QIs) prefer to address this issue upfront. This approach helps identify potential concerns early. If the other party is unfamiliar with the 1031 exchange process, it can be explained from the outset, preventing issues later. This practice is widely used in the industry.
Notify the Other Party at Closing
Some advisors caution that putting a Cooperation Clause or a notice of doing a 1031 exchange in the offer to purchase contract could be used as leverage by the seller, since it will alert them to the fact that you may have 1031 exchange timing requirements and other unique processes with which you must comply.
Additionally, some advisors warn that Cooperation Clauses will make a real estate transaction appear more complicated than it actually is, particularly when dealing with an agent or counterparty that is not familiar with 1031 rules and procedures. Such notices and clauses could also cause the seller to select an offer from another buyer who is not doing a 1031 exchange, as the seller may think it would be simpler and smoother.
To get around this concern, notice about the exchange can be left out of the real estate contract and added as part of the closing process just before settlement. This is typically a standalone, single-page document outlining the exchange and informing the other party that they are not impacted by the 1031.
It is impossible to know in advance how the other party will respond to the disclosures or to the timing of the notice. Please consult your advisors for their guidance.
What is an Assignability Clause?
Some real estate forms contain No-Assignment clauses. If the form contract you are using has such a clause, it will need to be removed for the exchange to proceed.
On the other hand, some contracts include an Assignment Clause that explicitly allows assignment. An Assignability Clause states that the buyer/seller in this contract (the exchangor) has the right to assign their rights to someone else (the QI). Without this clause, the entire exchange could be in jeopardy because the transfer of rights wouldn’t be allowed.
Should I include an Assignability Clause?
Legal professionals differ on whether this is necessary. The conservative approach is to remove the No-Assignment clause and specifically add an Assignment Clause. However, if you have a Cooperation Clause and remove the No-Assignment clause, many believe you should be good to go without adding an additional assignment clause. Remember to check with your legal advisor for their take on your unique situation.
Conclusion
Whether you use a Cooperation Clause or a simple notice of a 1031 exchange, it is crucial to ensure that your contract allows assignment to a Qualified Intermediary. These clauses, while small, play a significant role in keeping your 1031 exchange on track.
Understanding how and when to provide notice about your 1031 exchange, whether through a Cooperation Clause or a simple notice, is a key component of a successful exchange. You must also decide whether to include an Assignability Clause. There is no single best way or time for making the disclosure; many professionals suggest doing so upfront in the purchase contract, while others prefer to disclose later.
Consult your tax or legal advisor and seek guidance from your Qualified Intermediary to determine the best approach for your situation. Including these concepts in your discussions with advisors can help you draft your purchase offer and address the necessary disclosures effectively. Remember, in the world of 1031 exchanges, proactive planning and clear, timely communications are essential.