Recently, a friend of mine expressed frustration about the fact that his newly completed 1031 exchange took a lot longer than he had expected. His transaction went through without any major hiccups, and did come in under the 180-day closing deadline, but the length of the transaction still irritated him. Unfortunately for my friend, he was unaware that there is a contractual tool that can be used to help 1031 transactions go through in a speedier fashion. This contractual tool is referred to as a contingency clause.
Contingency clauses can be useful tools to help steer your 1031 transaction in a manner that best serves your interests—without compromising your eligibility for 1031 treatment. With a bit of planning and effort, you can use contingency clauses in your contract to develop a smooth 1031 transaction that fully satisfies your needs.
Contingency Clauses Provide You with a Greater Level of Control over Events
A contingency clause establishes that a certain condition (or set of conditions) must be met for a contract to become enforceable. A contingency clause may also be used to allow for an alternative means to complete a transaction in the event that the primary means becomes unavailable.
For example, in section 1031 scenarios that involve both you and another party, a contingency clause may state that a cash payment will be given in the event that a certain property is unable to be acquired by a specific date. Contingency clauses of this kind can bring substantial benefits to you as an investor. By imposing a deadline, you are effectively steering the transaction to suit your needs and exercising an increased level of control over events. Time carries value, and so contingency clauses can quite literally be used to make a transaction more valuable to you.
You may be wondering: can a 1031 exchange contract include a contingency clause of this kind (or similar kind) and still remain valid? It’s a reasonable concern—after all, a contingency clause that allows for a cash payment option seems to express a conflicting intention to receive 1031 treatment, and our intentions often have significant weight under the law. As it turns out, though, courts have ruled that contingency clauses of this kind do not bar 1031 treatment—as long as the exchange of like-kind properties takes place.
Alderson v. Commissioner and the Weight of Contingency Clauses in 1031 Exchanges
The case of Alderson v. Commissioner of Internal Revenue (1963) was a key decision that contributed toward an understanding of how section 1031 is interpreted. In this case, Mr. Alderson agreed to sell his property to a die casting company. But before the sale was completed, Mr. Alderson located a property he wished to acquire from the company in place of the cash sale. The company agreed to acquire the property and then transfer it to Mr. Alderson as part of a 1031 exchange.
As is usually the case with real estate transactions, time was an important factor to Mr. Alderson, and so he included a contingency clause in his contract stating that if the desired property were not acquired by a certain date, the company would instead pay cash for his property. This clause undoubtedly motivated the company to move quickly, and they successfully acquired the desired property, exchanged it for Mr. Alderson’s property, and concluded the 1031 transaction.
The government tried to argue that the parties did not truly intend to make an exchange, and that the transaction was actually a sale (and therefore taxable). The court—in this case, the Ninth Circuit Court of Appeals—rejected this argument and ruled that the most critical factor in the determination of 1031 treatment is whether an exchange of like-kind properties has actually transpired, not whether an option for a cash sale was part of the contract. The Ninth Circuit quoted directly from Mercantile Trust Co. v. Commissioner: “... the above-mentioned agreement of March 7 evidenced an intention to exchange the Baltimore Street property if certain conditions were met, and to sell it, if those conditions were not met. Those conditions were met. The property was, in fact, exchanged. That fact is controlling here.”
Courts will view your 1031 exchange as a whole and will base their decision on the “substance” of the transaction. And if an exchange of like-kind property has taken place, then clearly it will fall within the meaning of section 1031. Your contract can include a contingency clause that places certain obligations on the other party and, as long as an exchange of like-kind property occurs, you should still receive 1031 treatment. In effect, this allows you to have a certain level of control over the transaction without incurring any penalties.
Of course, you need to bear in mind that if you do receive a cash payment for your property, your transaction will be regarded as a sale and will be taxable. But just because Mr. Alderson included a contingency clause for cash payment does not mean that you have to do the same. Your own contingency clause could provide for a different outcome in the event that your desired property can’t be acquired. Maybe you would prefer to include a contingency stating that a secondary property can be used to complete the transaction; or you may simply wish to have the option to abandon the transaction if your desired property can’t be acquired by a specific date. Contingency clauses are versatile tools and can be molded to suit your needs.
Covering all Bases When Taking Part in a 1031 Exchange
In 1031 exchanges, subtle things can make the difference between a smooth, orderly transaction and a transaction fraught with all kinds of difficulty and headache. If you go about your 1031 transaction without the help of a capable firm, understanding the function of contingency clauses can definitely help you.
But another option you have is to partner with a qualified real estate investment firm, which allows you to bypass many of the potholes that can turn up in 1031 transactions. At CWS Capital Partners, we have many years of experience helping our investors acquire new properties via 1031 exchanges. If you’d like to avoid some of the hassles that can come up in a 1031 exchange, partnering with a reputable firm like CWS Capital Partners could be the best move for you. Contact us today to get started.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
All investments involve risk including the possible loss of principal. You should familiarize yourself with all risks associated with any investment product before investing.
Advisory services are provided by CWS Capital Partners LLC, a registered investment advisor.
Securities offered by CWS Capital Partners LLC are through an affiliated entity, CWS Investments. CWS Investments is a registered Broker Dealer, member FINRA, SIPC.