- THE PURCHASE AGREEMENT
Whether you are buying or selling property, one of the most important and yet most often neglected documents is the purchase agreement. This is true whether the property is residential, commercial or bare land. The purchase agreement serves as the road map to the sale. It sets forth the buyer and sellers’ rights, duties and obligations. If there is a problem, the purchase agreement is the first place to look for the solution. Although most sales are completed without a problem, if one does arise, the purchase agreement becomes a valuable tool in determining the rights and obligations of the parties. If there is no purchase agreement or it is incomplete, the parties to the sale face the initial obstacle of interpreting the parties agreement, substantially increasing the costs and complexity.
Minnesota law provides a groundwork of what is required in the sale of land. As a point of beginning, the “Statute of Frauds” provides that any agreement for the sale of land must be in writing to be enforceable. There are several exceptions to the general rule, however, the best practice is to avoid having to apply one of the exceptions. The purchase agreement serves as the written agreement.
A well written purchase agreement will not only establish the price for the sale, but the specific duties of the buyer and seller. In particular, how taxes, abstracting, and closing costs will be paid, and whether there are any contingencies such as property inspections or financing. The agreement should further specify a closing date or that “time is of the essence” to prevent a closing date from being pushed indefinitely into the future.
- RESIDENTIAL CONSIDERATIONS
In the sale of residential property, there are certain disclosures which are required by the seller prior to executing the purchase agreement. Specifically, the seller is obligated to provide disclosures with regard to wells, septic systems, and lead paint. Further, as of January 1, 2003, the seller is also required to provide, a written disclosure to the prospective buyer which include all material facts pertaining to adverse physical conditions in the property of which the seller is aware that could adversely and significantly affect the buyers ordinary or intended use of the property. The failure to provide the required disclosures subject the seller to potential liability for claims and damages which may arise after the sale, even if the property is sold “as-is”.
For the buyer, the purchase agreement provides an opportunity to include protections allowing the buyer to back out of unfavorable purchase agreements. The most common contingencies are the inspection contingency and the financing contingency. The inspection contingency allows the buyer to have the house inspected by a professional. In the event that major defects are found, the buyer can terminate the agreement and be entitled to a return of their earnest money. This is useful as the buyer is usually unfamiliar with the property and may not have the expertise to determine the condition of the property. Likewise, the financing contingency allows the buyer to terminate an agreement if they are unable to obtain the necessary financing to purchase the property. Thus, if the buyer enters an agreement and is subsequently denied financing, the buyer is entitled to a return of their earnest money.
If personal property, such as stoves, refrigerator, water softeners, window treatments, docks, etc are included in the sale, the buyer and seller may wish to allocate a portion of the purchase price to these items. This may be beneficial with regard to property valuations and taxes. If personal property is included in the sale, a bill of sale should be provided transferring the property to the buyer. While the buyer may desire a warranty on such property, the seller generally would like to sell the property “as-is.” Either choice should be specified in the purchase agreement.
Once a purchase agreement is signed, the seller is generally required to provide an abstract continued to date. The buyer should then determine whether the seller has marketable title, either through an attorney’s title opinion or title insurance commitment. The title opinion or title insurance commitment includes a review of the history of the property and will specify not only whether title is marketable or unmarketable, but also all recorded liens and encumbrances against the property. If title is unmarketable, the buyer must rely on the purchase agreement, which generally requires that the seller make title marketable at the sellers’ expense.
If the buyer is taking a mortgage to purchase the property, marketable title is required. However it is important to note that a title opinion for the bank or a mortgagee’s title insurance policy does not necessarily extend to the buyer. Moreover, when the mortgage has been satisfied, the policy is extinguished. To protect the buyers interest, the buyer should request an owner’s title insurance policy or attorney title opinion.
A title insurance policy is similar to other insurance policies, if a problem arises, the holder of the policy may make a claim. If the error was not excepted from the policy, the insurer may be liable for the costs of correcting the defect. It is important to note that the policy will only pay to the amount of coverage. Under an attorney’s title opinion, the attorney is held liable for correcting errors and omissions in the opinion. However, if the attorney dies or cannot be located, it may be impossible to recover.
At or prior to closing, the buyer and seller should contact all utility companies (phone, electric, gas, cable, etc) and notify them of the change of ownership. This will ensure that the seller does not continue to be listed as the owner after the sale, and that the buyer will have service as of the date of closing. The same principal applies to homeowner’s insurance. The seller has no need to insure the property after closing and the buyer will want coverage as of the date of purchase. Lastly, if the buyer intends to homestead the purchased property, it is up to the buyer to complete the homestead application. If this is not completed by December of the year of purchase, the county may not grant homestead status to the property for the following year.
- COMMERCIAL CONSIDERATIONS
In the commercial context, there are fewer required disclosures, however, the seller must still disclose wells and private sewage systems. Additionally, the sale of commercial property presents opportunities for the seller to minimize present tax consequences.
Commercial sales frequently arise in the context of business sales. As such, the parties may allocate the purchase price among the assets of the business, including, the land, equipment, goodwill, non-compete agreements, consulting agreements, etc. Different assets are depreciated on different schedules, and depending on the tax circumstances of both the buyer and seller, allocating more or less of the purchase price to a particular asset may create significant tax advantages or disadvantages.
Similarly, commercial property or property held for investment may be used in a like kind exchange (a “1031 exchange”). A 1031 exchange allows the seller to defer the payment of capital gains where commercial or investment property is sold and “like” property purchased. This advantage is available for real and personal property, however, the property must be substantially similar. Although this may raise a question with regard to personal property, all real property is substantially similar. Thus, an owner may sell bare land and buy a duplex or sell a warehouse and buy a farm. However, to satisfy the requirements of the 1031 exchange there are a number of rules which must be strictly followed. Failure to exactly meet all requirements may result in an attempted exchange being disqualified, subjecting the owner to taxes, penalties, and interest.
In considering a 1031 exchange, the first question is whether the property is held for commercial or investment purposes. While there are no clear definitions, there are certain considerations which are instructive. If the owner uses the property for personal benefit, such as a lake home, it may not be considered investment property for purposes of a 1031 exchange even if there is an investment component to the purchase. Property may also change classification such that investment property is used for a personal benefit, or property held for a personal benefit becomes investment property. For example, if the previous lake home is rented and the owner uses the property for less than fourteen days a year, it may be considered investment property. Similarly, if the owner is in the business of buying and selling property (a “dealer”), the property may be considered “inventory” rather than investment property. However, even if classified as a dealer, not all property owned by a dealer is inventory, but dependent upon the purposes for which the property is held. Nevertheless, if there is a question in this regard, the owner should consult with an appropriate professional in advance of the proposed exchange to ensure that appropriate action is taken to clarify that the property is investment property.
Completion of a 1031 exchange requires advance planning. If the investment property has been sold, and the owner paid, it is too late to structure the sale as an exchange. Even if the owner uses the proceeds from the sale to buy other investment property, the exchange is disqualified. The owner cannot take possession of the proceeds prior to completion of the exchange or it is taxable. Similarly, the owner is not required to use all of the proceeds in an exchange for the purchase of the replacement property, however, any proceeds received by the owner would be taxable.
The original 1031 exchange envisioned a simultaneous event, effectively, one owner trading investment property for other investment property. However, under the present rules, an exchange may be completed over a maximum of 180 days. The owner sells the relinquished property and the proceeds are paid to an intermediary. The owner then has 45 days to identify up to three replacement property totaling no more than 200% of the value of the relinquished property. The owner must then close on one or more of the replacement properties within 180 days. However, the sale must be completed within one tax year, thus, if a sale is made December 31, the replacement property must be purchased by April 15 when the prior year’s taxes are due. These time lines are strictly construed. If they are missed by one day, for any reason, the exchange is disqualified and the sale is a taxable event.
If considering a 1031 exchange, consultation with an appropriate profession is recommended. The rules are complex and the consequences of a failed exchange are significant. Nevertheless, a 1031 exchange is a useful tool in minimizing the immediate tax consequence of a commercial or investment sale.