Documentation

This chapter collects the drafting requirements that are scattered across the regulation and organizes them by document. Nothing here is new law. What is new is the arrangement, because the regulation states these requirements in the order it happens to define its terms rather than in the order a practitioner encounters them.

52.1 The exchange agreement

Eight requirements govern the agreement between the taxpayer and the qualified intermediary, and each traces to a specific provision.

It must be written and must require four acts. A qualified intermediary enters into a written agreement with the taxpayer and, as required by that agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.¹ An agreement that recites a service relationship without obligating those four acts has not created a qualified intermediary.

The intermediary must not be a disqualified person.² The determination is made against the lookback date fixed by the transfer of the first relinquished property, as Chapter 28 develops, and the conclusion should be recorded rather than assumed.

It must expressly limit the taxpayer's rights. The safe harbor applies only if the agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the intermediary.³ This is the single most important clause in the transaction.

The limitation must name the taxpayer. The regulation's negative example is unambiguous: an agreement that limits the intermediary's rights but not the taxpayer's does not satisfy the requirement, because the intermediary is not the taxpayer for safe harbor purposes.⁴ The instinct to restrict whoever holds the money is natural and it accomplishes nothing.

The limitation must say what the regulation requires it to say. The agreement must provide that the taxpayer has no rights, except as the two permitted exceptions allow, to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period.⁵ The permitted exceptions are a release after the identification period where the taxpayer has identified nothing,⁶ and, where the taxpayer has identified, receipt of all replacement property to which the taxpayer is entitled or the occurrence, after the end of the identification period, of a material and substantial contingency that relates to the exchange, is provided for in writing, and is beyond the control of the taxpayer and of any disqualified person other than the person obligated to transfer the replacement property.⁷

The drafting consequence of that last exception is easily missed. A contingency must be provided for in writing in the agreement, in advance. A contingency identified after it occurs is not one.

Any interest or growth factor must be separately limited. The safe harbor for interest applies only if the agreement pursuant to which the taxpayer is or may be entitled to it expressly limits the right to receive it in the same manner.⁸

The treatment of earnings should be stated. The default is that exchange funds are treated as loaned to the facilitator, which reports the income; that default is displaced only where the agreement provides that all earnings attributable to the taxpayer's funds are paid to the taxpayer.⁹ Silence produces a result most clients do not expect, as 27.4 develops.

Where a qualified escrow or trust is also used, its agreement must independently satisfy the same requirements. More than one safe harbor may be used in the same exchange, but the terms and conditions of each must be separately satisfied,¹⁰ and the escrow holder or trustee must independently not be the taxpayer or a disqualified person.

One drafting convenience is worth knowing. An identification made in a written exchange agreement signed by all parties before the end of the identification period satisfies the identification requirement without a separate notice.¹¹ Where the replacement property is known at the outset, putting it in the agreement removes a deadline.

52.2 Assignment and notice provisions

The assignment is what allows the intermediary to be treated as having done the four acts of 52.1 without appearing in the chain of title.

An intermediary is treated as entering into an agreement if the rights of a party to that agreement are assigned to the intermediary and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of property.¹²

Three requirements, and each is a place transactions fail.

Written. Oral notice does not satisfy the provision, and neither does an assumption that the other side's counsel is aware.

All parties. Not the counterparty of convenience. Every party to the agreement being assigned.

On or before the date of the transfer. This is a single day deadline, unlike the forty five and one hundred eighty day periods, and it cannot be cured afterward.

Direct deeding depends on it. An intermediary is treated as acquiring and transferring the relinquished property if it enters into an agreement with a person other than the taxpayer for the transfer of that property and the property is transferred to that person pursuant to that agreement, and correspondingly for the replacement property.¹³ Direct deeding works because of the assignment, not instead of it. An exchange in which the deeds ran directly and the assignment was never completed has an intermediary that acquired nothing, as 24.4 develops.

The operational discipline is to prepare the assignment and the notices with the closing package and to obtain acknowledged receipt at or before closing, rather than treating them as post-closing administration. A signature obtained the following week does not cure the omission.

Reverse exchanges run the deadline in the opposite direction, which is the one place in this work where a deadline runs forward from the event. The qualified exchange accommodation agreement must be entered into no later than five business days after the transfer of qualified indicia of ownership to the exchange accommodation titleholder, must provide that the titleholder is holding the property for the taxpayer's benefit to facilitate an exchange, must specify that the titleholder will be treated as the beneficial owner for all federal income tax purposes, and must be reported consistently by both parties.¹⁴

Because every other deadline in exchange practice runs backward from a closing, the five business day window is the one practitioners miss. It should be calendared on the day the titleholder takes title.

52.3 Cooperation clauses in purchase contracts

Nothing in the regulation requires a cooperation clause. The regulation requires an assignment and a written notice to all parties,¹⁵ and the clause is how counsel makes sure those can happen. A purchase contract that prohibits assignment defeats the structure before it starts.

What the clause should accomplish.

Permit assignment of the party's rights under the contract to a qualified intermediary, or in a reverse structure to an exchange accommodation titleholder.

Obligate the counterparty to execute an acknowledgment of the assignment notice at or before closing, which converts the notice requirement from a hope into a contractual obligation.

State that the cooperation is at no additional cost, expense, or liability to the counterparty, which is what makes the clause acceptable to the other side.

State that the exchange will not delay the closing or extend any deadline, for the same reason.

Preserve the counterparty's remedies against the original contracting party notwithstanding the assignment, so that the counterparty is not asked to accept an intermediary's covenant in place of a principal's.

What the clause should not do.

It should not condition the closing on the success of the exchange. A closing contingent on the taxpayer's tax result gives the counterparty a reason to renegotiate and gives the government a fact.

It should not create a binding commitment linking the exchange to a separate transaction the taxpayer wants treated independently, for the reasons developed at 42.1.

Two structure-specific points. In an exchange-last reverse structure the contract must permit assignment to the titleholder and the lender must be prepared to lend to the titleholder or its single member company, which is the practical constraint identified at 30.4 and 30.7. And in any transaction with a foreign seller, the contract should address the withholding certificate application described at 48.2, because that application must be filed on or before the closing date and the buyer bears the withholding obligation.

52.4 Settlement statement mechanics

The settlement statement is the document an examiner reads first, and it is the primary evidence of who received what.

Four things it must show correctly.

The intermediary as the recipient of proceeds. Funds wired to the taxpayer's own attorney, property manager, or a controlled escrow have been received by a person very likely to be the taxpayer's agent, and receipt by an agent is receipt by the taxpayer.¹⁶ Wiring instructions carry far more weight than their clerical appearance suggests and should be confirmed before the closing rather than corrected after it.

Transactional items, identified as such. Items that relate to the disposition or acquisition and appear under local standards in the typical closing statements as the responsibility of a buyer or seller are disregarded in applying the safe harbors, and the regulation names commissions, prorated taxes, recording or transfer taxes, and title company fees.¹⁷ Items a seller may receive that are not included in the amount realized, such as prorated rents, are separately disregarded.¹⁸

Items outside those categories, segregated. Financing costs and operating prorations that benefit the taxpayer personally are not within the regulation's description, as 33.5 develops. Where such an item is material and doubtful, the conservative course is to pay it from outside funds, which under 33.3 offsets debt relief and is therefore rarely wasted.

The mortgage payoff. That figure establishes the debt relief that drives the entire boot computation of Chapter 34, and it must be legible on its face.

One caution that follows from Chapter 39. Where exchange expenses are paid at the relinquished closing out of the gross price, they have already reduced the cash the intermediary receives. The return position must not reduce boot by them a second time. The settlement statement is the record that establishes which items were paid from the proceeds and which from outside funds, and it is the document that resolves the question years later.

The practice. Have the settlement agent categorize each line item before closing, and have the intermediary confirm in writing which items it will fund. A disagreement discovered at the table is resolved by whoever is in the greatest hurry, which is never the person with the tax exposure.

Retention. The settlement statements for both closings should be retained permanently, along with the exchange agreement, the assignment and notices, the identification, and the Form 8824. That file must survive decades and changes of accountant, for the reasons developed at 37.4, and assembling it at closing costs nothing.