1031 Exchange: Do I need cooperation in my cooperation clause?
The IRS has issued various private letter rulings over time that has developed interpretation structure for a host of issues surrounding the 1031 exchange. A history lesson on the evolution of section 1031 will be helpful to show why the use of an exchange cooperation clause was essential and then over time, as the IRS issued various rulings for interpretation, the clause is no longer needed.
Historically, the section 1031 made its way into the tax code in the early 1920’s, over a century ago. At that time, until mid-century, the sale and purchase were thought to need to take place “simultaneously”, at the same time. The statute read….
“No gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment”.
Over time though a series of court cases sought to clarify the expected time from simultaneously to something more specific, and then the US legislature got involved. They concurred that section 1031 did not require the exchange of the properties to take place simultaneously, but to want to limit the entire duration of the sales and purchase 180 days or less. A timeframe close enough link the transactions, anything longer would void the transactions for tax exempt purposes.
Identification and purchase period to qualify for 1031 exchange
As it was designed, a taxpayer had 45 days from selling their property to identify potential replacement properties and 135 days to close on one or more of the properties designated-with 180 days combined for the entire exchange. The timeframe was easier than coordinating a simultaneous sale.
Word traveled about this redesigned financial tool and 1031 exchange went from being a seldom used provision to defer tax to a foundation for a lifetime of investment real estate transactions.
Problems arose. What to do with the buyer’s funds during the interim period between the sale and purchase? A solution brought forth was to allow the buyer to retain the funds with the contractual obligation to use them to buy the new property once the seller was ready to do so. This was deemed an awful idea with way too much risk.
Lawyers eventually developed an idea to keep the exchange open between the taxpayer and the buyer and park the funds from the sale in a trust account managed by a third party (to keep the funds away from the buyer). This idea was ½ way there but required reluctant buyers to approve an exchange document that they wanted no part of. Buyers didn’t want to get involved in a tax matter that did not otherwise involve them, and the buyers didn’t want to pay their lawyers to review the lengthy contract.
Solution: The exchange cooperation clause?
The only way the seller could obligate the buyer to sign exchange paperwork necessary agreement was to provide for the buyer’s agreement as part of the purchase/sale agreement. Thus, a clause started to appear in contracts for this purpose requiring the buyer to execute the trust agreement. The clause eventually became known as the exchange cooperation clause.
The clause was well regarded at the time, but still more questions and problems arose.
Who was eligible to hold the funds in the trust?
Who retained the interest income in the trust deposit?
If the taxpayer picked out new property for the buyer to acquire to trade back to the taxpayer, did the buyer have to come into the chain of title?
The exchange cooperation clause necessity
For today’s exchanges and with modern law, the seller can assign the rights under the sale contract to the QI and notify the fact of this limited assignment to the parties to the contract. The parties receiving the written notice (mainly the buyer and later the seller) are not required to agree, cooperate or even to sign acknowledging receipt. The often sign as a professional courtesy, but nothing is required.
Regarding the replacement property contract the same thing must be done. This assignment in not an outright assignment of the whole contract to a third party, rather it is just the assignment of the seller’s rights (but not the obligations) in the contract for purpose of getting tax deferral.
In conclusion, the rules have changed over time and IRC Section 1031 has involved since its inception. There was a time when it was necessary to have a clause in the sale contract requiring the buyer to cooperate in the seller’s exchange transaction.
The featured change for buyer cooperation were the 1990’s era IRS regulations replacing the buyer and their cooperation with a third party, the Qualified Intermediary (QI). to remove the buyer from any need to cooperate. This voided the exchange cooperation clause in exchange contracts.
The only modern-day requirement for an exchanger in this regard is to assign the rights under the contract and provide written notice of the fact. There is no requirement for the buyer to cooperate in any way, but the written notice should be well documented for future need (if necessary).
Directrust℠ 1031 exchange services (Directrust℠) performs the duties of a qualified intermediary (QI) and does not provide due diligence to third parties regarding prospective investments, platforms, sponsors, dealers or service providers. Directrust℠ 1031 exchange services does not provide investment, legal or tax advice. Individuals should consult with their investment, legal or tax professionals for such services.