Does an Exchange Cooperation Clause Constitute as Identification of Replacement Property for 1031 Exchange Purposes?

What is the Exchange Cooperation Clause? 

The Exchange Cooperation Clause, was an additional document instated after the Starker Case ruling which allowed 1031 Exchanges to be non-simultaneous, it required the Buyer of property involved in an exchange to “cooperate” with the exchange.    

Why was the Exchange Cooperation Clause Needed?  

To better understand how the Clause came into effect, it is beneficial to start from the inception of Section 1031. IRC Section 1031 first made its way into the Tax Code in 1921, providing tax deferral when there was a “continuity of investment”. In this time period, it was thought that an exchange of Relinquished Property for Replacement Property had to be simultaneous and therefore “identification” of Replacement Property was irrelevant. 

In 1983, simultaneous exchanges were no longer required as a result of the decision in the Starker case. The case concluded that an exchange does not have to be simultaneous to be valid. This monumental change for 1031 Exchange occurred prior to the role of the Qualified Intermediary, which meant an Exchanger planning to do a non-simultaneous 1031 Exchange would need the Buyer to cooperate in order for the 1031 Exchange to be valid.  

The shift from simultaneous to delayed transactions raised the issue of handling sale proceeds. If the Seller controlled the proceeds, it would indicate a sale, not an exchange. To avoid this, the funds had to remain out of the Seller’s control and be used by the Buyer to purchase the Replacement Property, but that did not come without risks. 

Risks of the Buyer being left with control of the funds included the Buyer not preserving the funds or facing liens, claims, or judgements tying up the money. A solution was to place the funds in a trust account, known as a Starker Trust, where neither the Seller nor the Buyer had access during the 45/180-day period. This ensured the funds were used for the Replacement Property or returned if no exchange occurred. 

Initially, Sellers asked Buyers to sign the Starker Trust agreement at closing, but Buyers often resisted due to the complexity, deteriorating relationships, and need for legal review, sometimes resulting in additional fees for the Seller. Thus, resulting in an issue for the Exchanger who still needed the participation of the other party in order to complete a successful 1301 exchange. 

The Solution: The Exchange Cooperation Clause 

Based on the challenges noted above, it was determined the only way a Seller could compel a Buyer to sign the necessary agreement was to include the Buyer's obligation within the purchase/sale agreement. Consequently, what became known as the Exchange Cooperation Clause began to appear in contracts, requiring the Buyer to execute the Starker Trust agreement. 

The solution to this issue was to put language in the Purchase and Sale Agreement stating that the Buyer and/or Seller, as the case may be, would agree to “cooperate” with the other party attempting an exchange. Initially this language would get added to the Agreement, but in current times the language is often part of the standard sales contract. 

Language found in contracts vary, but below is an example of a simple Exchange Cooperating Clause: 

“Each of the parties hereto may assign its rights (but not its obligations) to Qualified Intermediary as defined in (and part of a tax deferred exchange) Internal Revenue Code 1031 and the Treasury Regulations thereunder acting to facilitate an exchange under Section 1031 and the regulations. Said exchange will be closed without cost, liability or delay to the non-exchange party.” 

Does an Exchange Cooperation Clause Constitute Replacement Property Identification? 

Some may wonder if the existence of the Exchange Cooperation Clause satisfies the Identification Requirements set forth in the Tax Reform Act of 1984. The Tax Reform Act of 1984 introduced time limits, the 45-day and 180-day identification requirements, and criteria to distinguish an exchange of properties from a traditional sale of a property and later purchase of a property.  

Below are the absolute requirements to comply with the Identification rules: 

2) MANNER OF IDENTIFYING REPLACEMENT PROPERTY.  

Replacement Property is identified only if it is designated as Replacement Property in a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to either – 

(i)     The person obligated to transfer the replacement property to the taxpayer (Regardless of whether that person is a disqualified person as defined in paragraph (k) of this section); or  

(ii)    (ii) Any other person involved in the exchange other than the taxpayer or a disqualified person (as defined in paragraph (k) of this section).  

There are several elements to the identification requirement noted above. First, the property has to be designated as Replacement Property, appear in a written document, signed by the Exchanger, and delivered to a party to the transaction, in this case the Seller, before the end of the 45-day identification period. So, does the existence of the Exchange Cooperation Clause satisfy all of these requirements?  

A contract between Seller and Buyer executed within 45 days of the Relinquished Property covers four of the five above requirements, but it is difficult to take the position that a pre-printed Exchange Cooperation Clause in a form contract constitutes the subject property as “designated” Replacement Property.   

However, in situations where the contract, with or without an Exchange Cooperation Clause and is altered from its standard state explicitly stating that the Buyer is designating this property as their 1031 Exchange property, it would seemingly meet all requirements above. But absent that, simply relying on the existence of an Exchange Cooperation Clause does not appear to meet the identification requirements. 

With the introduction of the role of the Qualified Intermediary in the 1991 Regulations, the participation of the other party within a real estate transaction involving a 1031 Exchange was no longer necessary. In today’s contracts, the Clause is still typically included in preprinted contracts or added for precaution but is not truly necessary. As the rules and requirements under IRC Section 1031 evolved over the past decades, what was once a crucial practice requiring the Buyer to “cooperate”, is a thing of the past.  

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.