May2000LU.PDF

Option definition

WB-24

Option to Purchase

Option terms

Lease with an option

to purchase

Simultaneous

like-kind exchanges

The revised

WB-35 Simultaneous

Exchange Agreement

Basic tax principles

Conclusion

Inside This Issue

WISCONSIN

REALTORS

Although the WB-24 Option to

Purchase and the WB-35

Simultaneous Exchange Agreement

are not frequently used forms, REAL-

TORS

should be familiar with the

forms and the situations where their

use is appropriate. The Wisconsin

Department of Regulation and

Licensing (DRL) has recently revised

these forms to put them on letter-

sized paper and to make them more

versatile for broker use. This Legal

Updatereviews the changes that have

been made to the Option to

Purchase, and the Simultaneous

Exchange Agreement forms.

This Legal Updatefirst reviews the

definition of an option, distinguish-

ing it from a right of first refusal. The

Updatealso overviews the general

legal principles that control a REAL-

TOR

’s use of this technique for

acquiring real estate. A discussion of

the changes made to the revised WB-

24 Option to Purchase follows. By

popular demand, the need to com-

plete an offer to purchase form and

attach it to the Option to Purchase

has been eliminated. Instead, the

revised WB-24 returns to the former

format where various standard offer

to purchase provisions are included

within the WB-24 form itself. The

discussion of the revised option con-

cludes with pointers for creating a

lease with an option and making sure

that the option to purchase will be

enforceable.

The Legal Updatealso discusses the

simultaneous, like-kind exchange

transaction. The Updatebegins with

some basic definitions and concepts

involved in Internal Revenue Code

(IRC) § 1031 like-kind exchanges.

The Update then examines the

revised WB-35 Exchange Agreement,

which is designed for simultaneous

exchanges, and overviews the tax

treatment of like-kind exchanges

under the IRC.

The tax materials in this Updateare

provided as general background

information for the exclusive benefit

of our members. Only general tax

provisions are covered – there are

often twists and turns behind these

general principles, depending upon

the facts and circumstances. REAL-

TORS

, clients, and customers want-

ing to take advantage of any of these

tax nonrecognition methods must

seek the advice of their own account-

ants and tax attorneys. The specific

transactional circumstances and the

taxpayer’s personal financial status

may impact the tax benefits to be

derived or dictate alternative strate-

gies.

The Law of Options

An option to purchase is, in simple

terms, a continuing promise to sell.

The seller agrees to sell the property

to the buyer, upon the terms stated in

the agreement, if the buyer exercises

the option to purchase by the stated

deadline. If the option is exercised, it

has the effect of a purchase contract.

This section of the Updatedefines an

option to purchase. An option is

legally required to be in writing and

Revised WB-24 Option to Purchase

& WB-35 Simultaneous Exchange Agreement

Legal Update

A WRA Publication Exclusively for the Designated REALTOR

Please Route to:

__ ___________

WRA 00.05

EDITORIAL STAFF

Author

Debbi Conrad

Production

Sonja Penner

Elizabeth Hicks

Rick Staff

Debbie McNelly

ASSOCIATION

MANAGEMENT

President

Bill Berland

Executive VP

William E. Malkasian, CAE

ADDRESS/PHONE

The Wisconsin

REALTORS

Association,

4801 Forest Run Road,

Suite 201, Madison,

WI 53704-7337

(608)241-2047

1-800-279-1972

LEGAL HOTLINE:

Ph (608) 242-2296

Fax (608) 242-2279

Web:www.wra.org/

member/legalhotlineq.htm

The information contained herein

is believed accurate as of 05/24/00.

The information is of a general

nature and should not be

considered by any member or

subscriber as advice on a particular

fact situation. Members should

contact the WRA Legal Hotline

with specific questions or for

current developments.

Reproduction of this material may

be done without further permission

if it is reproduced in its entirety.

Partial reproduction may be done

with written permission of the

Wisconsin REALTORS

Association Legal Department.

Contacts

WISCONSIN

REALTORS

Legal Update 00.05

to be time-is-of-the-essence. The

option fee generally will be nonre-

fundable. In the following subsec-

tions, the option also is contrasted

with a first right of refusal.

Option Definition

An option is a contractual right to

buy a property at a stated price dur-

ing a stated time period. The option

agreement will be between the owner

of the property and the potential

buyer who is reserving the right to

purchase the property. The owner of

the real estate is the potential seller,

also called the optionor. The other

person – the potential buyer – is

called the optionee. For the purposes

of discussion in this Update, however,

we will refer to the optionor/owner

as the seller and optionee/potential

buyer as the buyer. This is the termi-

nology used in both the 1995 and the

2000 versions of the WB-24 Option

to Purchase.

The seller is bound by the option and

cannot sell the property to anyone

else while the option is in effect. The

seller cannot revoke or withdraw the

option and the option is not termi-

nated by the seller’s death or incapac-

ity. The buyer, on the other hand, is

not bound to take the property or pay

for it – the buyer has the option to

take it or leave it. In other words, the

buyer has bargained for and obtained

an offer to sell from the seller, and the

buyer has the privilege of making up

his or her mind about whether or not

to accept that offer and proceed to

buy the property. The buyer typically

will conduct inspections and tests,

check zoning and other applicable

ordinances, determine the availability

of financing, and generally ascertain

the suitability of the property for the

buyer’s intended purpose before pro-

ceeding. The buyer exercises the

option by giving the seller written

notice that he or she will purchase the

property.

Option Must Be In Writing

An option creates an interest in lands

and thus it is a conveyance, as defined

in Wis. Stat. Chapter 706. Any con-

veyance must be in writing to be

valid, and must contain the elements

listed in § 706.02: the option must be

in writing and identify the parties, the

real estate, and the interest conveyed;

the option must state any material

terms and conditions, including the

consideration; and the option must

be signed by the seller.

The requirements also apply to any

option extension agreement and to

the buyer’s exercise of the option.

Any separate agreement extending

the option should state the consider-

ation for the extension, or if there is

none, restate the original considera-

tion from the option. The buyer’s

exercise of the option (like an accept-

ance of an offer) must be in writing.

Time-is-of-the-Essence

The general rule for options is that

time is of the essence, whether or not

the agreement specifically so provides.

The buyer must exercise the option by

the stated deadline if the option is to

become a purchase contract. The

buyer exercises the option by deliver-

ing written notice to the seller indicat-

ing that the buyer wants to proceed

with the purchase. If the buyer does

not exercise the option by the stated

deadline, the option expires without

further notice. At that point in time,

the buyer’s rights to purchase are

automatically forfeited.

The general time-is-of-the-essence

rule, however, can be contractually

modified, if the parties so direct, by

striking the phrase “exercise of this

option” from the time-is-of-the-

essence provision in the WB-24 and

indicating in the additional provisions

lines that time will not be of the

essence for the exercise of the option.

Nonrefundable Option Fee

If the buyer pays cash for an option

and then fails to exercise the option,

he or she generally cannot have the

option fee back. The seller gives up

the right to sell the property to any-

one else throughout the term of the

option and gives the buyer the exclu-

sive right to buy the property upon

the stated terms and conditions. The

buyer pays for this privilege via the

nonrefundable option fee. If the

buyer lets the option expire without

exercising it, the buyer still received

the benefit of the consideration he or

she paid for the option.

First Right of Refusal

Distinguished

A first right of refusal is somewhat

similar to an option, but there are

also some important differences. A

person with a first right of refusal is

not entitled to buy the property, but

rather only has the right to buy the

property if the seller decides to sell it.

The buyer with a right of first refusal

cannot compel the seller to sell sim-

ply by delivering a written notice.

Generally, the right to buy under a

first right of refusal is upon the terms

and conditions offered by another

third-party buyer. Since the buyer

typically must agree to match the

terms of an offer to purchase made by

a third-party buyer in order to exer-

cise the first right of refusal, the terms

and conditions of that offer must be

given to the buyer. This creates prob-

lems for real estate licensees involved

in the transaction under the present

§ RL 24.12 confidentiality of offers

rule. See the discussion of this prob-

lem in the following Legal Hotline

question and answer:

A prospective buyer wants to rent a

$295,000 home with an option to buy

or lease the home with right of first

refusal. How to proceed?

The first right of refusal most often

given in real estate transactions pro-

vides that the potential purchaser has

the first right to buy the particular

property upon the terms and condi-

tions offered by another buyer. The

person given the first right of refusal

has the right to match the price, terms,

and conditions offered by a second

buyer. This presumes that the terms

and conditions of the offer made by

the second buyer must be given to the

person holding the first right of refusal

so he or she can decide whether to

match those terms and buy the prop-

erty or let the other prospective buyer

purchase the property.

The implementation of a first right of

refusal poses a problem for Wisconsin

real estate licensees because of the

current § RL 24.12 confidentiality of

offers rule. Under § RL 24.12, a

licensee cannot reveal the terms of

one person’s offer to another

prospective buyer or to another per-

son with the intent that the terms be

revealed to another prospective

buyer.

Thus, in a first right of refusal situa-

tion, the licensee cannot supply the

person who has the first right of

refusal with the terms and conditions

of the second buyer’s offer. The par-

ties and/or their attorneys must han-

dle this process. As long as the cur-

rent rule remains in effect, a licensee

arguably should not even deliver a

sealed envelope to the person with

the first right of refusal if the enve-

lope contains the terms of the other

offer to purchase. This may change,

however, in the event that § RL

24.12 is revised.

In an option to purchase, on the

other hand, the seller agrees that the

prospective buyer is entitled to buy

the property at an agreed upon price

and upon the stated terms at any time

during the specified term of the

option. During this time period, the

seller cannot revoke the option. The

buyer decides when and if to buy, and

is not reliant upon a third-party buyer

to initiate the process, as is the case

with a first right of refusal. The buyer

also negotiates the terms and condi-

tions of the potential offer in advance,

again not dependent upon the third-

party buyer’s terms and conditions.

In exchange, the prospective buyer

typically pays a nonrefundable option

fee. The option becomes a contract

only if the prospective buyer exercis-

es the option in the manner specified

in the agreement before the term of

the agreement ends. The terms of

this contract are those stated in the

option – no additional contract need

be written if the buyer exercises the

option.

The Updatenow turns from the law

of options to the implementation of

those principles in the revised option

form. The new WB-24 form, which

has an optional use date of June 1,

2000 and a mandatory use date of

January 1, 2001, is reviewed in the

next section.

The New WB-24

Option to Purchase

A draft copy of the new WB-24

Option to Purchase form (2000

option) temporarily can be found on

the WRA Web site in the members-

only section. To access the WB-24

sample, go to the WRA Web site at

http://www.wra.org/realtors

, select

Legal in the left-side navigation bar

and then look in the table of contents

for the sample form. Once the form is

finalized, it will be included in

ZipForm.

By popular demand, the need to com-

plete an offer to purchase form and

attach it to the Option to Purchase

has been eliminated in the 2000

option, which returns to the prior for-

mat where various standard offer to

purchase provisions are included

within the WB-24 form itself.

The beginning few lines of the 2000

option resemble the standard provi-

sions found in an offer to purchase

form, such as the confirmation of

agency relationship and the property

identification. At that point, however,

the 2000 option shifts to sections

3Wisconsin REALTORS

Association Legal Update 00.05

dealing with the Deadline for Grant

of Option and the Option Terms;

items not customarily found in an

offer.

Deadline for Grant of Option

The new provision found on lines 7-

8 of the 2000 option provides for an

acceptance deadline that must be met

in order for the option to be valid.

The option shall be invalid unless a

copy of the WB-24 signed by all of

the owners (sellers) of the property is

delivered back to the buyer by the

deadline stated on line 8. Time is of

the essence.

In other words, the option is treated

just like the offer to purchase in terms

of binding acceptance – the accepted

contract must be delivered back to

the buyer by the specified acceptance

deadline. Delivery is subject to the

Delivery of Documents and Written

Notices section at the top on page 4

of the 2000 option. If the seller

chooses to counter the option pro-

posal or reject it, the seller will do so

by initialing the proper line near the

bottom of page 4.

This “delivery back” provision is new.

Under the 1995 version of the WB-

24, any negotiation back and forth

between the buyer and the seller was

not really contemplated and it was

apparently assumed that the seller

and buyer would arrive at a consensus

agreement and decide to execute the

WB-24, more or less concurrently.

The 2000 option instead anticipates

back-and-forth negotiation similar to

the discussions that occur when an

offer is being worked out. If a count-

er-offer is necessary, the WB-44

Counter-Offer may be modified and

used with the 2000 option.

Option Terms (Lines 9-20)

These are the provisions for the

implementation of the 2000 option,

including the option fees, the exercise

of the option, any extension of the

option, and recording.

The Option Fee.

Line 9 of the 2000 option states the

amount of the option fee and the

deadline for paying it. The deadline is

expressed in terms of number of days

from the granting of the option. The

option is granted on the date the sell-

er signs the option. Under the 2000

option, the option fee is not refund-

able if the option is not exercised, and

the amount stated on line 10 shall be

a credit against the purchase price if

the option is exercised. The parties

may apply an amount less than the

full option fee to the purchase price,

leaving a portion of the option fee

that goes to the seller for the costs of

the option process.

Exercising the Option.

The deadline for the buyer’s exercise

of the option is stated on line 12. The

buyer has until midnight of the stated

day to deliver written notice to the

seller. The applicable delivery meth-

ods are stated near the top of the

fourth page of the form, and mirror

the delivery provisions found in the

offer to purchase.

The buyer may complete the Notice

of Exercise of Option section at the

very end of the 2000 option and use

that for his or her notice. A different

notice format may also be used such

as a modified WB-41 Notice Relating

to Offer to Purchase, a notice pre-

pared by the buyer’s attorney, or a

notice written by the buyer. The

notice should identify the property,

the parties, and the date of the

option, and state that the buyer is

exercising the option.

Extending the Option.

Lines 13-16 of the 2000 option may

be completed to provide for a pre-

arranged extension of the option

upon payment of the stated extension

fee by the stated extension payment

deadline. The new extended deadline

is indicated on line 13. If the exten-

sion provisions are completed, all the

buyer has to do is to pay the seller the

option extension fee by the payment

deadline and the option automatical-

ly will be extended to the indicated

extension date. Just like the original

option fee, the extension option fee is

not refundable if the option is not

exercised, and a stated amount of the

fee shall be a credit against the pur-

chase price if the option is exercised,

with the balance going to the seller.

Any additional automatic extensions

should be stated in the Additional

Provisions section on page 4 of the

2000 option or in an addendum to

the form. Such provisions should

state the amount of the additional

extension fee, the buyer’s deadline

for paying the fee, and the new

extended option deadline. If an addi-

tional extension is needed after the

option has been granted, the addi-

tional extension may be drafted on a

modified WB-40 Amendment to

Offer to Purchase, or may be pre-

pared by an attorney or the parties.

Such an extension agreement may be

needed, for example, if the buyer can-

not complete testing or a zoning

change by the first extension date and

thus needs a second extension.

Holding the Option Fee.

Lines 16-18 of the 2000 option

address the issue of to whom the

option fee and any extension fees

should be paid: directly to the seller

or to the listing broker’s trust

account. The parties must strike the

choice that does not apply. If the fees

are held in the broker’s trust account,

there is a blank line that may be com-

pleted to indicate how long the bro-

ker shall hold the fees and to whom

the broker is to disburse the fees. For

example, the option may be complet-

ed to say until “the exercise of the

option, and then paid to the seller,”

or “the effective date of the lease and

then disbursed to seller after offset-

ting cash advances.”

Recording the Option.

Lines 19-20 of the 2000 option warn

that failure to record the option with

the register of deeds may allow other

Legal Update 00.05Wisconsin REALTORS

Association

persons to acquire an interest in the

property with priority over the option

holder. The parties may choose to

record or not record either the

option to purchase or a separate doc-

ument that gives notice that the

option is in existence. The buyer is

well advised to record the option or

some notice thereof to ensure that

the seller does not sell the property to

someone else or create liens upon the

property during the term of the

option or any option extension.

If the option is to be recorded, the

option must be modified to meet the

Wis. Stat. § 706.05 requirements for

recordable documents. The legal

description of the property and the

tax parcel identification number or

PIN will have to be included under

Additional Provisions or in an adden-

dum to the option. The signature of

the seller also must be acknowledged

by a notary public or authenticated

by an attorney before the option may

be accepted for recording.

Format Requirements

of Recorded Documents.

Wis. Stat. § 59.517 provides that no

instrument or document can be

recorded in the office of a county

page substantially complies with cer-

tain requirements for the first page of

the document. The front page must

include the name of the instrument at

the top of the document, an area in

the upper left corner of the document

for the document number, an area in

the upper right hand corner of the

document for recording information,

an area for the return address, and a

space for the PIN. If this sounds

familiar, it is the format long used in

State Bar conveyancing forms such as

warranty deeds. The first page must

also contain the names of the

grantees and grantors, the return

address, and a legal description in

type large and dense enough to be

copied in a legible manner.

The Register of Deeds must provide,

without charge, a blank form that

may be completed and used as the

first page of any real estate document

that a person wants to record. The

form may be completed, stapled to

the top of the document, and then

recorded. This will require an extra

$2 in recording fees because of the

additional page.

Recording a Separate Instrument.

Many times the parties do not want

to make the terms and conditions of

the option public and may prefer to

avoid recording what may often be a

somewhat lengthy document. The

2000 option plus its attachments will

usually be at least five pages (record-

ing cover sheet, four-page WB-24).

As an alternative, the parties and their

attorneys may prepare a separate

recordable document that gives

notice that the seller has granted an

option to the buyer. Such an instru-

ment must identify the seller and the

buyer, and give the legal description.

It may simply indicate that the buyer

has an equitable interest in the prop-

erty, or that the buyer has an option

to purchase the property. It may be

prudent to state the term of the

option and any extension periods

stated in the WB-24.

For example, one of the party’s attor-

neys may draft an Affidavit of

Interest, a Notice of Option, or some

other brief form. The seller, buyer, or

both may sign such a document,

although a form signed by the seller

may be more persuasive than a self-

serving document signed by only the

buyer. The document would also

need to comply with the recorded

documents formatting requirements.

The buyer and the seller may wish to

state in the option which party’s

attorney shall prepare any separate

option notice document and which

party will pay for the preparation

costs and recording fees if the parties

do not want to record the WB-24.

Terms of Purchase

In an option to purchase, matters

such as inspections, testing, financ-

ing, rezoning, etc. will be handled by

the buyer after the granting of the

option and before the option is exer-

cised. Accordingly, there generally are

no contingency provisions. As stated

in the Buyer Due Diligence provision

on page 2 of the 2000 option, the

buyer may need to perform testing,

inspections, and investigations;

obtain financing, permits, estimates,

maps, and zoning variances; review

business and governmental records;

and check on anything else necessary

for the buyer’s evaluation of the

property. All of this is done at buyer’s

expense. The buyer must find out

everything he or she needs to know

in order to decide whether or not to

purchase the property.

If everything falls into place in a man-

ner that is satisfactory to the buyer,

the buyer will exercise the option and

promptly proceed to closing. If the

buyer is dissatisfied, the buyer may

seek an amendment to the option

terms or will simply not exercise the

option. The buyer might also seek a

termination of the option and then

write a new offer to purchase based

on the results of his or her inspec-

tions, testing, and investigations.

Inspections and Tests

A crucial part of the 2000 option is

the inspection and testing provisions

found at the top of page 4. While in

an offer to purchase, the provisions

and contingencies for inspections,

testing, financing and other matters

are contained in the offer or addenda

and are performed after acceptance of

the offer but prior to closing, the tim-

ing in an option situation is different.

The presumption is that all inspec-

tions, testing, and other contingen-

cies will have been completed to the

buyer’s satisfaction prior to the time

that the buyer exercises the option.

Because of this, inspection and other

contingencies will usually be unnec-

essary in an option. For example,

where an offer will often contain an

5Wisconsin REALTORS

Association Legal Update 00.05

inspection contingency, in an option,

all that is needed is that the buyer has

the right to inspect. If the buyer is

satisfied, he or she may exercise the

option. If the buyer is unhappy with

the property condition, he or she may

simply not exercise the option, may

attempt to negotiate an amendment

to the option which addresses the

buyer’s concerns, or may not exercise

the option and instead draft an offer

to purchase based upon property

information the buyer now has.

The 2000 option simply indicates at

the top of page 4 that the buyer is

authorized to conduct the inspec-

tions and tests that that are listed on

the lines provided. As in an offer to

purchase, the buyer’s inspectors and

testers are granted reasonable access

to the property upon reasonable

notice, as stated in the Inspections

and Testing standard provisions on

page 2 of the 2000 option.

Inspections and tests that might be

performed prior to the exercise of the

option include a home inspection, a

roof inspection, soils testing for septic

systems, well water testing, and test-

ing for lead-based paint. The inspec-

tion and testing provisions generally

will only specify how the inspection

and testing will be performed and not

how the inspection and test results

will be evaluated. The buyer can

impose his or her own evaluation

standards in deciding whether to

exercise the option.

Testing provisions should state the

types of testing that are authorized,

who may perform the testing, the

purpose of the tests, any limitations

on the testing, and other conditions

such as the buyer’s obligation to

return the property to its original

condition. For example, the buyer

and his or her investigators may be

authorized to obtain samples of the

well water for testing at a state-

approved laboratory; or the buyer

and his or her testers may be author-

ized to test the soils to determine

suitability for a conventional septic

system by performing no more than

20 soil borings at the buyer’s desig-

nated construction site, provided that

any holes are filled upon completion

of testing.

Specialized Provisions

The buyer must add any specialized

provisions pertaining to the particular

type of property involved. The agent

working with the buyer may wish to

review the DRL-approved offer to

purchase form that would be used if

the buyer were writing an offer to

purchase on the property to deter-

mine what other additional provi-

sions may need to be incorporated

into the option. An addendum may

be required for this purpose. While

there may not be any additional pro-

visions that need to be added for a

residential transaction, a farm, com-

mercial or business opportunity

transaction may require numerous

additional provisions. For example,

the buyer may need to authorize

record reviews and searches and

obtain the seller’s consent and sup-

port while working with government

agencies on issues such as zoning or

agricultural chemical clean up.

Generic Provisions

Most of the rest of the 2000 option

is comprised of generic standard pro-

visions that would be found in most

of the different kinds of offer to pur-

chase transactions. These include the

purchase price, additional items

included in the purchase, items not

included in the purchase, conveyance

of title, place of closing, occupancy,

leased property, closing prorations,

zoning, representations regarding

the property and transaction, proper-

ty dimensions and surveys, property

damage between exercise of option

and closing, pre-closing inspection,

condominium disclosures, title evi-

dence, special assessments, deliv-

ery/receipt, dates and deadlines, fix-

tures, entire contract, default, deliv-

ery of documents and written

notices, time of the essence, addi-

tional provisions, and addenda. A

few of the standard provisions are

discussed in detail in the following

sections.

Property Condition Representations.

Just like in an offer to purchase, the

seller in the 2000 option makes rep-

resentations concerning the condi-

tion of the property and the transac-

tion. The form contemplates that the

buyer will have received any Chapter

709 real estate condition report

required for one- to four-family resi-

dential property as well, or any other

seller condition report for non-resi-

dential properties, prior to the

buyer’s signing of the option. This

section follows the format of an offer

to purchase.

The “conditions affecting the

Property or transaction” listed in the

2000 option are modeled after those

found in the vacant land offer to

purchase, so the buyer may wish to

add additional conditions appropri-

ate to the type of property involved

in the option. The effective date of

these representations is the date on

which the seller grants the option.

The seller also agrees to notify the

buyer if any “condition affecting the

property or transaction” which is

materially inconsistent with the sell-

er’s initial representations arises

between the granting of the option

and the exercising of the option.

Time is of the Essence.

The 2000 option makes the exercise

of the option, the payment of the

option fee, the payment of any

extension option fee and all other

dates and deadlines time is of the

essence. It is especially important

that the buyer be aware that the

buyer must meet the deadline for the

exercise of the option because this

deadline will be strictly enforced.

The buyer can lose the property to

another buyer if the buyer’s notice is

late, which would be particularly

tragic if the buyer has invested exten-

sive time and money in evaluating

the property.

Legal Update 00.05Wisconsin REALTORS

Association

Assignability.

The 2000 option presents the parties

with a choice on page 4, following the

Time is of the Essence provision,

regarding the assignability of the

option. If the option were assignable,

that would mean that the buyer, for

instance, may assign all of his or her

rights and interests under the option

to any third party of the buyer’s

choosing, without any additional con-

sent from the seller. If the seller wish-

es to limit a buyer’s right to assign the

option, the seller may wish to add

additional terms and conditions to the

option. For example, an additional

provision might specify that the buyer

may only assign to third parties that

are pre-qualified for a loan in the

amount of 90% of the purchase price

and who are willing to accept the

property “as is.”

Leases with an Option

to Purchase

Many times an option will be used in

conjunction with a lease. A licensee

drafting in this situation would use a

lease form or rental agreement draft-

ed by the owner or by an attorney

(such as the WRA Residential Rental

Contract or the WRA Rental

Agreement) provided the form iden-

tifies the drafter. The WB-24 would

be attached to the lease and incorpo-

rated by reference.

In this scenario, the option may pro-

vide under Additional Provisions or in

an addendum that all or part of the

rent paid prior to the exercise of the

option will be applied to the purchase

price if the option is exercised. It may

also be helpful to indicate what hap-

pens to the rest of the rent if the

option is exercised and what happens

to the rent paid if the option is not

exercised, just to make sure the parties

clearly understand the arrangement.

Lessons Learned

from Option Enforcement

The reported case law on options is

usually about buyers who sued the

seller for specific performance of the

option. The sellers in these cases

often claim that the buyer did not

timely exercise the option or failed to

comply with other conditions related

to exercising the option. The buyers

often claim that the sellers, by their

actions and words, have lost the right

to insist upon timely performance

under the doctrine of estoppel. This

scenario suggests a few pointers for

licensees working with options to

remember.

Specific Performance

An option to purchase contemplates

specific performance by its own

terms. A specific performance remedy

awards the performance that was

promised instead of awarding just

monetary damages. To be enforce-

able in specific performance, the

option must be a valid binding con-

tract and must have been exercised.

The court may be unable to grant

specific performance if the contract

terms are vague or uncertain. If some

of the essential terms required to cre-

ate a contract are left open for the

parties’ future determination, the

contract will not be sufficiently cer-

tain and complete to permit specific

performance. In addition, the buyer

seeking specific performance of an

option must have performed every-

thing he or she was supposed to do

before seeking specific performance

by the seller.

✍ The lesson here is obvious – make

sure that all the terms and conditions

of the option are clear and crisp. A

provision leaving a condition of the

option to the later determination of

the parties may be fatal to the buyer’s

ability to seek specific performance if

the seller fails to perform.

Exercise of the Option

REALTORS

may wish to make sure

that the buyer fully and completely

understands the provisions for the

exercise and the extension of the

option. These provisions are time-is-

of-the-essence and must be strictly

and precisely followed. The buyer

cannot rely upon there being any

grace periods. As illustrated in the

next section, it is possible that the

seller may voluntarily or inadvertent-

ly waive the time-is-of-the-essence

deadline, but there is no guarantee.

✍ The exercise of the option is an all-

or-nothing proposition. If the notice

of exercise of the option or the

option extension fee is 10 minutes

late, the option will automatically and

immediately expire.

Estoppel

Timely performance may be waived

or the time for performance may be

extended by the seller through his or

her words, actions, or failure to act.

The buyer may claim the seller is

“estopped” or prevented from insist-

ing on precision in the exercise of the

option. For example, if the seller’s

words or actions suggest to the buyer

that it is OK if the buyer waits until

after the holiday weekend to send the

notice of exercise of the option, and if

the buyer can show reasonable

reliance upon the seller’s words or

deeds, the buyer may succeed in

being able to exercise the option with

a notice that is late.

REALTORS

working with a seller

should caution their client to never

suggest or discuss any extensions

with the buyer without having it put

in writing and signed by the parties.

Verbal discussions with the buyer

may be misunderstood and cause a

serious disagreement over issues as

critical as the exercise of the option.

✍ The seller is best served by taking

the hard line position that all option

deadlines will be strictly observed and

that extensions will not be honored

unless in writing.

Buyer’s Advance Resale of Option

Property

The case law makes it clear that the

option may be enforced by specific

performance, which is an equitable

7Wisconsin REALTORS

Association Legal Update 00.05

remedy, because the option gives the

buyer an equitable interest in the title

to the real estate. This equitable

interest also may give the buyer suffi-

cient interest in the property for the

buyer to resell the property, even

before the option is exercised and the

purchase is closed.

If a buyer has a binding option to

purchase a property, the buyer legally

has sufficient interests in the property

to proceed with the resale of all or

part of the property being purchased.

A binding option is one that has no

conditions precedent, in other words,

is contingency-free – this is generally

the case with an option. The buyer

has equitable ownership interests in

the property that are created by a

binding option contract.

If the buyer wishes to sell all or part

of the property for which the buyer

has a binding option, licensees may

list and market the property for the

buyer on a contingent basis. The list-

ing contract and any offers must be

contingent upon the buyer success-

fully closing on his or her purchase of

the property. In addition, any mar-

keting activities physically taking

place on the property will require the

consent of the original seller who still

holds legal title to the property and

who may still occupy the property.

Such activities may include survey

work, showings, and signs.

If the licensee’s company has the

original listing for the optioned prop-

erty, however, the licensee must also

obtain the written consent of the first

seller before concurrently listing the

property a second time for the buyer.

This avoids any appearance of a con-

flict of interest. The first seller might

otherwise question why any pur-

chasers that the licensee obtains for

the buyer were not procured as pur-

chasers for the seller under the first

listing. This would especially be true

if the offers obtained for the buyer

were more favorable than those

offered by buyer in the option.

Simultaneous

Like-Kind Exchanges

Although people tend to think of real

estate transactions primarily in terms

of sales and leases, exchanges often

provide an attractive financial alterna-

tive. Certain exchanges of property

are not taxable. This means that any

gain from the exchange is not imme-

diately taxed, and any loss is not

immediately deducted. The gain or

loss is not recognized until the prop-

erty received is sold or disposed of.

Sales and purchases that are not made

because of tax consequences or the

unavailability of funds sometimes

may be accomplished as exchanges.

Under § 1031 of the Internal

Revenue Code (IRC), exchanges of

real property may be made in which

no gain or loss is immediately recog-

nized, if certain conditions are met.

First, there must be an exchange

transaction and not a sale. An

exchange is a reciprocal transfer of

properties, as distinguished from a

transfer of property for money.

To qualify for this tax-free treatment,

the property that is transferred and

the property that is received must be

held for productive use in a trade or

business, or for investment. This is

based on how the party used the

transferred property during the two-

year period ending on the date of the

exchange, and how the new property

will be used during the two-year peri-

od beginning on the date that the

party received it in the exchange.

Machinery, buildings, land, trucks,

and rental houses are examples of

property that may qualify. The rules

for like-kind exchanges do not apply

to exchanges of partnership interests

or property held primarily for sale,

such as inventories, raw materials,

and real estate held by dealers.

§ 1031 exchanges must also involve

like-kind property. The exchange of

investment real estate for investment

real estate is an exchange of like prop-

erty. For example, the trade of an

apartment building for a retail build-

ing is a like-kind exchange. However,

an exchange of personal property for

real property does not qualify as a

like-kind exchange. For example, an

exchange of a piece of machinery for

a store building does not qualify.

“Like-kind” refers to the category or

class of the property, not the specific

type of property. Generally, invest-

ment and/or business properties may

be swapped on a tax-free basis while

personal real estate like a principal

residence or second home, or person-

al property like a boat or stock can-

not. Rental real estate, vacant land,

and farms, which generally are all

business and/or investment property,

can be exchanged for other invest-

ment and/or business real estate such

as office buildings, warehouses, and

vacation rental properties. A party is

not limited to exchanging one office

building for another, but instead may

exchange the office building for resi-

dential rental real estate or farm

property. In addition, the exchange

of owned real estate for a real estate

lease that runs 30 years or longer also

is a like-kind exchange.

Two primary types of like-kind real

estate exchanges fall under IRC

§ 1031: the simultaneous like-kind

exchange and the deferred or delayed

exchange of like-kind real estate,

often referred to as a Starker

exchange. Both types of exchanges

involve the nonrecognition or defer-

ral of the time when the party must

pay any capital gains taxes. The dis-

tinguishing feature is the timing of

the actual real estate transfers. In the

simultaneous exchange, properties

are concurrently traded, generally at

the same closing. In the deferred or

delayed exchange, one property is

conveyed away but another property

need not be received until a few

months later.

The focus of this Legal Updateis the

“swapping deeds at the same closing

table” variety of exchange; in other

Legal Update 00.05Wisconsin REALTORS

Association

words, the simultaneous exchange.

For a discussion of Starker or

deferred exchanges, see Legal Update

97.01, obtain a copy of IRS

Publication 544, “Sales and Other

Dispositions of Assets” (see

http://www.irs.ustreas.gov/prod/

search/index.html), or go to the IRS

Web site at http://www.irs.ustreas.

gov/prod/forms_pubs/pubs/p5440

105.htm. There also are several dif-

ferent Web sites that discuss Starker

Exchanges including http://www.

taxprophet.com/pubs/stark_ar.html,

and http://www.exchanging.com

/tutorial.html.

The Revised

WB-35 Simultaneous

Exchange Agreement

In the following discussions, the

existing WB-35 (mandatory use date

7/1/96) will be referred to as the

“1996 exchange agreement,” and the

revised WB-35 will be referred to as

the “2000 exchange agreement.”

The 2000 exchange agreement is

based on the WB-15 Commercial

Offer to Purchase, but also contains

some residential provisions that will

be beneficial in transactions where

residential rental properties are being

exchanged. The 2000 exchange

agreement has an optional use date of

June 1, 2000 and a mandatory use

date of January 1, 2001. A draft copy

of the 2000 exchange agreement

temporarily can be found on the

WRA Web site in the members-only

section. To access this sample, go to

the WRA Web site at

http://www.wra.org/realtors

, select

Legal in the left-side navigation bar

and then look in the table of contents

for the sample form. Once the form is

finalized, it will be included in

ZipForm.

Format

The 2000 exchange agreement is on

letter-sized paper and is six pages

long. The DRL is changing to letter-

sized paper for all new approved

forms to facilitate the faxing and

computer printing of documents.

The 2000 exchange agreement is

substantially the same as the 1996

exchange agreement. The various

provisions have been shuffled and

reorganized on the form, but most of

the provisions remain the same as in

the 1996 exchange agreement.

Simultaneous Exchanges

The 2000 exchange agreement is

designed for use in simultaneous

exchange transactions where the par-

ties sit across the table from one

another and swap deeds. The title of

the 2000 exchange agreement

includes the word “Simultaneous” to

emphasize this point. The 2000

exchange agreement may be used

regardless of whether the transaction

qualifies for tax nonrecognition as a

like-kind exchange under IRC

§ 1031. Although most parties who

exchange properties are looking for

the tax benefits of § 1031, there may

be exchanges that are not subject to

this tax treatment.

It is also possible that a property

transferred or received in a simultane-

ous exchange is used as a step in a

Starker exchange – thus the section

for Cooperation with “Like Kind”

Exchange has been included on page

4 of the 2000 exchange agreement.

This use, however, will be unusual.

Many of the provisions in the new

exchange agreement are the same or

closely resemble the provisions of the

commercial offer and the 1996

exchange agreement. This Update

reviews some of the significant provi-

sions unique to exchange transac-

tions. These provisions include the

tax warning and tax qualification con-

tingency, the terminology used to

identify the parties to the agreement,

boot and assumptions of mortgages,

seller disclosure reports, escrow clos-

ings, title insurance gap endorse-

ments, fair market value, and consent

to broker compensation from persons

other than the client. Discussion of

additional exchange agreement pro-

visions may be found in Legal Update

97.01.

Tax Warning and Tax Qualification

Contingency

The tax warning that appeared at the

beginning of the 1996 exchange

agreement has been moved to page 6

of the 2000 exchange agreement

where it is incorporated into the tax

qualification contingency. The 2000

exchange agreement warns that an

exchange transaction may have signif-

icant tax consequences and urges the

parties to seek their own tax advice.

The tax qualification contingency

allows a party to make the exchange

transaction contingent upon receiv-

ing a written opinion from a qualified

tax advisor that the transaction meets

the requirements of an IRC § 1031

like-kind exchange. The qualified tax

advisor may be an attorney, CPA, or

other professional designated by the

parties. A specific individual may also

be named to render the tax opinion.

If the written opinion states that the

transaction does not qualify for §

1031 benefits, the agreement will fail.

The written tax opinion must be

delivered to the other party by the

deadline stated in the contingency:

“within __ days of the latter of

acceptance or agreement as to fair

market value.”

The reference to “acceptance” refers

to the acceptance date of the

exchange agreement. “Acceptance” is

defined as the date when all parties

have indicated their acceptance by

signing an identical copy of the

agreement. This definition anticipates

that the exchange agreement may be

signed in counterparts, and confirms

that the acceptance date will be the

latest date on which a party signed

the agreement. The agreement as to

fair market value is discussed on page

11 of this Update.

Party Terminology

The clarification in the designations

of the First Party, Second Party,

9Wisconsin REALTORS

Association Legal Update 00.05

Property One, and Property Two is

one of the few substantive changes

made in the 2000 exchange agree-

ment. Each of these terms has its own

blank line where the party or proper-

ty is specifically named or identified.

The property the First Party is trad-

ing is referred to as “Property One,”

and the property the Second Party is

trading is referred to as “Property

Two.”

To understand the use of the terms

“Grantor” and “Grantee,” it may be

helpful to envision the exchange as

two concurrent sales. The terms

“Grantor” and “Grantee” are used

whenever both sides of the exchange

have identical duties. Where the

duties would vary, the terms First

Party and Second Party would be

used instead. For example, since both

parties must make property condition

representations and provide a disclo-

sure report regarding the property

they are trading, that section of the

form uses the terms Grantor and

Grantee. “Grantor” and “Grantee”

are defined on page 5 of the 2000

exchange agreement. The contingen-

cies on page 6 of the 2000 exchange

agreement, on the other hand, refer

to the First Party and the Second

Party because both sides will not nec-

essarily have the same contingency

provisions.

Boot and Mortgage Assumptions

In most exchanges, the respective val-

ues or equities in the properties being

exchanged are not equal. The equity

in a property, for exchange transac-

tion purposes, is the fair market value

of the property. One party must

accordingly give additional consider-

ation to balance the equities and even

up the trade. The cash or other non-

like-kind property given to even

things up is called “boot.”

Nonlike-kind property can be any

property that has value. For example,

an automobile, stocks, bonds, or a

personal residence may be used as

boot in an exchange transaction. If a

party transfers a property that is sub-

ject to mortgage liability that is

assumed by the party receiving that

property, this will also be considered

boot. The transferring party is treated

as if he or she received cash in the

amount of the outstanding mortgage

liability and paid off the mortgage.

In the exchange agreement, cash

boot should be listed as additional

cash consideration on line 11. Other

nonlike-kind consideration may be

listed on lines 12-14. The exchange

agreement cautions the parties to

address the details of any mortgage

assumption involved in the exchange.

A mortgage assumption agreement

may accordingly be included in the

exchange agreement on a separate

page attached as an addendum.

A mortgage assumption agreement

will indicate that Grantee agrees to

assume Grantor’s existing mortgage

on the property. The outstanding

mortgage balance (principal and

interest), the amount of the monthly

payments (principal and/or interest),

the annual interest rate, the time

remaining in the loan term, and any

other significant loan details should

be specified. Because a mortgage

assumption generally requires the

lender’s approval, the mortgage

assumption agreement also may

include a contingency requiring that

the Grantor obtain the lender’s writ-

ten approval of Grantee’s assumption

of the mortgage by a specified dead-

line. A mortgage assumption agree-

ment may also address whether the

Grantor will be released from all lia-

bility under the loan and whether the

Grantee is purchasing any loan

escrow accounts for real estate taxes,

insurance, loan insurance, etc. A

lender also may require that some

modifications be made to the loan

terms as a condition of granting per-

mission for assumption by the

Grantee – these may also be stated if

known in advance.

Property Condition Representations

The type of disclosure report used

and whether the report is mandatory

or optional will depend upon the type

of property being transferred in the

exchange transaction.

Commercial/Industrial Properties

There is no approved seller’s disclo-

sure report for commercial proper-

ties, so licensees are free to create

their own reports, or to use the

WRA’s Real Estate Condition Report

- C. This form has been designed to

serve as (1) the seller’s written

response to the listing broker’s

inquiries about the condition of the

property being listed, as required by

§ RL 24.07(1)(a); and (2) the

Grantor’s disclosure report which is

referenced in the 2000 exchange

agreement.

Properties Containing

One to Four Residential Units

If a property contains one to four

dwelling units, the Wis. Stat. Chapter

709 (residential) real estate condition

report (RECR) is needed. As is dis-

cussed in Legal Update 96.09, the

RECR is required whenever there is a

transfer of real estate containing one

to four dwelling units, provided that

the transaction is not exempt. In such

transactions, a RECR containing the

required Wis. Stat. § 709.03 lan-

guage must be used. Such reports

include the WRA’s three-page sup-

plemented RECR (SCR), the two-

page basic RECR (CR), and the

RECR for farms (WRA-F). Such an

RECR must be completed with

respect to the whole property, not

just the rental units.

Vacant Land

The WRA’s Real Estate Condition

Report - V for vacant land transac-

tions is also not a DRL-approved

form, it is not a mandatory form, and

it is not a residential RECR. It is,

instead, a helpful and useful form

which facilitates a listing broker’s ful-

fillment of his or her § RL 24.07

vacant land inspection obligations,

and fulfills the Grantor’s obligation

Legal Update 00.05Wisconsin REALTORS

Association

to disclose “conditions affecting the

Property or transaction” to the

Grantee.

Escrow Closings

The Place of Closing provision on

page 3 of the 2000 exchange agree-

ment calls for a closing in escrow, and

prompts the parties to indicate

whether the escrow fees will be the

responsibility of the First Party, the

Second Party, or shared equally. If an

escrow closing is not desired, the

escrow language should be struck.

The purpose of the escrow closing,

which is explained in the middle of

page 4 of the form, is to try to ensure

that there are no intervening liens,

encumbrances, or other title defects

first appearing of record after the date

of the title commitments and before

the closing documents are recorded.

In an escrow closing, each party gives

the escrow agent all documents and

funds necessary to complete the

exchange transaction. The escrow

agent then checks the most current

title records available for review to

see if any unanticipated liens or

encumbrances have appeared. If not,

the escrow agent disburses the funds

and records the documents.

Gap Endorsements

Although the escrow closing does

decrease the risk of missing any new

liens or encumbrances appearing on

the title to the properties being

exchanged, there still may be a gap

between the time that documents

creating a lien or title defect are

recorded and when they are available

for search and review. There will also

be a gap between the effective date of

the title search conducted by the

escrow agent and the time that the

exchange documents are recorded.

When title insurance is used, howev-

er, these gaps may be more effective-

ly addressed with a gap endorsement

to the title insurance policy, as is stat-

ed in the bold-faced caution in the

middle of page 4.

The Grantee is

at risk for any title defects that first

appear of record during these “gap

periods.” Some of the title defects

which may appear of record during

the gap periods include mortgages,

such as second “home equity” mort-

gages; deeds to third parties; lis pen-

dens filings from foreclosures,

divorces, transactions with prior own-

ers, or boundary or encroachment

disputes with neighbors; construction

liens; federal tax liens; state tax war-

rants; and judgments.

The way to cover these gap periods

and provide more complete coverage

for the Grantee is to have the title

insurance company provide a “gap

endorsement.” Title insurance com-

panies will usually provide a gap

endorsement as a routine matter.

This endorsement causes the title

company to provide coverage for

intervening liens and title defects.

The endorsement may be provided

by some title insurance companies at

no charge, but more often the title

company will charge for the gap

endorsement. See Legal Update 96.02

at pages 5-6 for further discussion of

gap endorsements.

Fair Market Value

In sales transactions, the key dollar

amount is the sales price that is deter-

mined by mutual negotiation of the

parties. The sales price is used in

determining the income tax conse-

quences of the transaction, is

required by law to be stated on the

real estate transfer return, and is used

for computing the amount of title

insurance and casualty insurance.

In exchange transactions, there is no

negotiated sales price. A value needs

to be computed for these purposes.

The IRC and the real estate transfer

fee statutes indicate that this value

must be the fair market value. The

amount of the title insurance is also

tied to the fair market value in the

exchange agreement.

A simultaneous exchange requires

that the values being traded be equal.

In other words, there must be a bal-

ance of equity. Equity is determined

by looking at fair market value.

Because the transaction cannot legally

close without a fair market value

assigned to each of the properties

being exchanged, a mechanism for the

determination of fair market value

appears in the exchange agreement.

The fair market values of Properties

One and Two may be simply stated in

the Fair Market Value section in the

middle of page 4 of the 2000 exchange

agreement if known at the time the

agreement is executed. If not, the par-

ties are directed to come to a written

agreement as to the fair market values

by a deadline that is stated as a certain

number of days before closing. If the

parties are unable to reach such an

agreement, the parties must submit the

matter to binding arbitration. The cost

of any arbitration is to be split equally

between the parties and the closing

date shall be extended to accommo-

date the time spent in arbitration.

The Fair Market Value provision in

the exchange agreement allows the

parties to work on fair market values

virtually up until closing. The deal

can’t legally close until (and unless)

an agreement as to fair market values

is reached. The parties can, however,

amend the offer to extend the closing

date, and thus the deadline for an

agreement (which is based upon days

before closing). Such extensions will

avoid the time and expense of the

arbitration process.

11Wisconsin REALTORS

Association Legal Update 00.05

In exchange transactions, there is no negotiated

sales price. A value needs to be computed for

these purposes. The IRC and the real estate trans-

fer fee statutes indicate that this value must be

the fair market value.

Broker Compensation

The exchange agreement contains a

pre-printed acknowledgment and

consent by the parties to the receipt

by each broker of compensation from

persons other than the broker’s client

in the transaction. Wis. Stat. §

452.133(3)(a) and Wis. Admin.

Code § RL 24.05(1) prohibit brokers

accepting any fee or compensation

related to a transaction from any per-

son other than the broker’s client

without the prior written consent of

all parties to the transaction. This

exchange agreement provision pro-

vides that consent. The exchange

agreement cautions that this consent

to compensation is not the same

thing as a consent to multiple repre-

sentation.

Most of the remaining provisions of

the 2000 exchange agreement closely

follow the provisions of the commer-

cial offer. See Legal Update 00.01 for

further discussion of those provi-

sions.

Basic Tax Principles

The tax materials in this Updateare

provided as general background

information for the exclusive bene-

fit of our members. Only general

tax provisions are covered – there

are often twists and turns behind

these general principles, depending

upon the facts and circumstances.

REALTORS

, clients, and cus-

tomers wanting to take advantage

of any of these tax nonrecognition

or deferral methods must seek the

advice of their own accountants and

tax attorneys. The specific transac-

tional circumstances and the party’s

personal financial status may impact

the tax benefits to be derived or

dictate alternative strategies. These

extensive personal variables prevent

the Legal Hotline from giving

advice in this specialized area of the

law.

To comprehend the benefits and lim-

itations of like-kind exchanges,

REALTORS

first must understand

some basic tax principles. This section

of the Updateaccordingly reviews

some basic definitions of key income

tax concepts such as gross income,

realization of income, adjusted basis,

and recognition of gain.

Gross Income

The starting point in computing a

party’s tax liability for the year is cal-

culating the party’s gross income.

The IRC defines gross income as “all

income from whatever source

derived.” This is a very broad defini-

tion and basically covers any wealth

acquired including salaries, tips, divi-

dends, commissions, alimony, inter-

est, rent, gambling winnings, dis-

charge of debt, gains from business,

and gains from dealings in property.

However, some items such as gifts,

inheritances, life insurance proceeds,

and interest on state and local bonds

are not included in gross income.

Realization of Income

To calculate a party’s gains and losses

from property dealings, a party must

first determine whether a gain or loss

has been realized. Realization is a

term of art that is generally used to

refer to the time when property is

sold or exchanged. Although a prop-

erty’s value may fluctuate over time,

the party realizes such gain or loss

only upon the disposition of the

property (i.e., when it is sold or

exchanged). The amount the party

receives on the sale or exchange of a

property (contract sales price less sell-

ing costs) is called the amount real-

ized.

Adjusted Basis

The party realizes a gain if the

amount realized is more than the

party’s unrecovered investment in the

property. The party’s unrecovered

investment in the property (purchase

price paid plus improvements) is

called the adjusted basis. In the sim-

plest case, this would be what the

party paid for the property. In other

words, a party’s realized gain equals

the amount realized less the party’s

adjusted basis in the property sold.

The party realizes a loss if the amount

realized is less than the party’s unre-

covered investment in the property.

In other words, a party’s loss equals

the party’s adjusted basis less the

party’s amount realized.

For example, Tycoon buys a parcel of

vacant land for investment purposes

in year 1 for $1,000,000. In year 5,

Tycoon sells the land for $2,500,000.

Tycoon’s amount realized is

$2,500,000 and his adjusted basis is

$1,000,000 so his gain from the sale

is $1,500,000. As a result of the sale,

Tycoon will include $1,500,000 in

gross income. On the other hand, if

Tycoon sold the land in year 5 for

$750,000, Tycoon’s amount realized

would be $750,000, his adjusted

basis would be $1,000,000, and his

loss from the sale would be

$250,000.

The party’s adjusted basis in the

property, however, does not always

simply equal the amount the party

paid for the property. If Tycoon

instead purchased property that

would decline in value over time

due to exhaustion or wear and tear,

such as an office building or an

apartment complex, Tycoon would

be able to deduct, or depreciate,

part of the cost of the office build-

ing during the time he owned it.

Because raw land does not have a

limited useful life, Tycoon would

only be able to depreciate that por-

tion of the property attributable to

the actual office building or apart-

ment complex, not the land upon

which it sits.

If Tycoon was able to take $100,000

of depreciation deductions, his unre-

covered investment in the property is

no longer $1,000,000. Tycoon

recovered, for tax purposes,

$100,000 of his investment through

depreciation deductions, so his unre-

covered investment would now be

$900,000. Tycoon’s original basis is

$1,000,000, while his adjusted basis

is now $900,000. If Tycoon sold the

Legal Update 00.05Wisconsin REALTORS

Association

office building for $1,500,000, his

realized gain would be $600,000.

Recognition of Gain

A party must next determine whether

and when the gain realized will be

recognized. A realized gain can be

included in gross income only if it is

recognized. Recognition of a gain or

a loss means that the gain or loss will

in fact be taken into account in com-

puting the party’s actual income.

Although most realized gains are

generally recognized at the time of

the transaction, Congress has created

some exceptions which allow the

gains (and sometimes the losses) to

be deferred or recognized at a later

date. Among these nonrecognition

rules are the rules for simultaneous

like-kind exchanges.

Simultaneous

Exchanges Under §1031

IRC § 1031 allows a party to delay

paying taxes on a gain realized from a

simultaneous exchange of property if

certain conditions are met. The party

must have held the property

exchanged for productive use in a

trade or business or for investment

purposes. The old property must be

exchanged for a new like-kind prop-

erty that will also be used either for

productive use in trade or business or

for investment purposes.

Although a party will not have to rec-

ognize any gain at the time of the

transaction, the gain is not perma-

nently released from taxation. In an

IRC § 1031 simultaneous exchange,

the gain that would be recognized is

delayed or deferred by assigning the

basis of the old property transferred

to the new property received.

For example, suppose Jane exchanges

an apartment building, which has a

fair market value of $500,000 and an

adjusted basis of $100,000, for a

warehouse, which has a fair market

value of $500,000. Jane would real-

ize a gain of $400,000 ($500,000

amount realized less $100,000

adjusted basis), but she will not have

to recognize that gain. As a result of

the exchange, Jane’s adjusted basis in

the warehouse will be $100,000, the

same as Jane’s adjusted basis in the

apartment building. If Jane, however,

were to sell the warehouse immedi-

ately after the exchange, she would

realize and recognize the $400,000

gain that she realized but did not rec-

ognize in the §1031 exchange.

Transactions Involving Boot

The basic tax treatment of a simulta-

neous like-kind exchange may be

modified depending upon the boot

(cash and/or unlike-kind property)

that is transferred. The following

basic overview of some of these tax

consequences is designed to give the

REALTOR

a basic understanding of

the principles involved. These tax

concepts are presented on a simpli-

fied basis. A party must, of course,

consult with his or her tax profession-

al for a specific evaluation of the tax

consequences to that party.

Payment of Cash Boot

If, in addition to transferring like

property, a party pays money in a

like-kind exchange, the party still has

no taxable gain or deductible loss.

The basis of the property received is

the basis of the property given up,

increased by the amount of money

paid. For example, if Bill trades one

vacant lot for a new one. The new lot

has a fair market value of $20,000.

Bill’s lot has a fair market value of

$12,000 and pays $8,000 cash boot

in an exchange transaction. Bill has

no taxable gain or deductible loss on

the transaction regardless of the

adjusted basis of his old lot

($10,000). Instead, Bill has a basis in

the new lot of $18,000 ($10,000 old

lot basis plus $8,000 cash boot paid).

Receipt of Boot

If, in addition to like-kind property,

the party receives money or unlike

property in an exchange, the party

may have a partially taxable exchange.

The party may be taxed on gain real-

ized, but only to the extent of the

money and the fair market value of

the unlike-kind property received.

For example, a party exchanges real

estate held for investment for other

real estate that the party wants to

hold for investment. The party also

receives $1,000 in cash boot. The

$1,000 cash will be recognized and

included in the party’s income.

Assumption of Liabilities

If a party to a like-kind exchange

assumes any of the liabilities on the

property that the party receives, the

party transferring that property will

be treated as if he or she received cash

in the amount of the assumed liabili-

ty. This occurs if a party exchanges a

property that is subject to a mortgage

liability that is assumed by the party

receiving the property.

Unlike Property Transferred

If, in addition to like property, a party

transfers unlike property as boot, the

party must recognize any gain or loss

on the unlike property transferred.

The gain or loss is equal to the differ-

ence between the fair market value of

the unlike property and its adjusted

basis.

For example, a party exchanges stock

and real estate that was held for

investment for real estate that the

party also intends to hold for invest-

ment. The stock transferred has a fair

market value of $1,000 and an adjust-

ed basis of $4,000. The real estate

transferred has a fair market value of

$19,000 and an adjusted basis of

$15,000. The real estate received has

a fair market value of $20,000. The

party will not have a taxable gain on

the exchange of the real estate

because it qualifies as a nontaxable

exchange. However, the party must

recognize and report a $3,000 loss on

the stock because it is unlike property.

Multiple-Party Transactions

The like-kind exchange rules also

apply to property exchanges that

13Wisconsin REALTORS

Association Legal Update 00.05

involve three- and four-party transac-

tions. Any part of these multiple-

party transactions can qualify as a

like-kind exchange if it meets all of

the requirements. Under the like-

kind exchange rules, the party must

generally make a property-by-proper-

ty comparison to figure his or her

recognized gain and the basis of the

property received in the exchange.

The parties to a multi-party exchange

should seek the assistance of their

accountant or tax specialist when

planning and reporting these types of

transactions.

Reporting the Exchange

The exchange of like-kind property is

reported on Form 8824. The instruc-

tions for the form explain how to

report the details of the exchange.

The exchange must be reported even

if no gain or loss is recognized. If the

party has any taxable gain because

money or unlike property was

received, the party should report it

on Schedule D (Form 1040) or Form

4797, whichever applies.

Exchange expenses, such as broker-

age commissions, attorney fees, and

deed preparation fees may have to be

subtracted from the consideration

received to figure the amount real-

ized on the exchange, and added to

the basis of the like-kind property

received. The party should consult

with his or her tax professional for

assistance with these computations.

The tax materials in this Updateare

provided as general background

information for the exclusive benefit

of our members. Only general tax

provisions are covered – there are

often twists and turns behind these

general principles, depending upon

the facts and circumstances. REAL-

TORS

, clients, and customers want-

ing to take advantage of any of these

tax nonrecognition or deferral meth-

ods must seek the advice of their own

accountants and tax attorneys. The

specific transactional circumstances

and the party’s personal financial sta-

tus may impact the tax benefits to be

derived or dictate alternative strate-

gies. These extensive personal vari-

ables preclude the Legal Hotline

from giving advice in this specialized

area of the law.

Conclusion

The option is really a standing offer

to sell. The option differs from an

offer to purchase because the buyer

typically evaluates property condi-

tions, financing availability, applicable

ordinances, etc. prior to the exercise

of the option. Because of this, there

rarely are any contingencies in the

option.

The revised WB-24 Option to

Purchase differs from the prior form

because the need to complete an

offer to purchase form and attach it

to the Option to Purchase has been

eliminated. Instead, the revised WB-

24 returns to the former format

where various standard offer to pur-

chase provisions are included within

the WB-24 form itself. The WB-24

may need to be supplemented with

an addendum of additional provi-

sions, however, to tailor the form to

the specific type of transaction

involved.

The revised WB-35 Simultaneous

Exchange Agreement is a specialized

form for use in specialized exchange

transactions that permits parties to

take advantage of some attractive

IRC tax benefits. The tax deferral

provisions are very complicated and

should be utilized by a party only

upon the advice and under the guid-

ance of a competent tax advisor. Care

must also be used because the differ-

ent tax provisions discussed in this

Updatemay also be modified or elim-

inated. When working together,

however, with a client’s tax advisors,

licensees can help generate attractive

financial outcomes using simultane-

ous exchanges.

Legal Update 00.05Wisconsin REALTORS

Association

This

Legal Update

and other

Updates

beginning with

92.01 can be found in the

members’ section of the

WRA Web site at:

http://www.wra.org/realtors

A subscription to theLegal

Updateis included in all

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REALTOR

dues.

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Legal Update, and other

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and Affiliate

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Each subscription includes

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Contact the Wisconsin

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Suite 201, Madison,

WI, 53704-7337

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WISCONSIN

REALTORS

15Wisconsin REALTORS

Association Legal Update 00.05

NOTES

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