A. Gain or Loss in Exchange
Where a taxpayer “trades up” in a like-kind exchange by acquiring property more valuable than the property relinquished and no boot is received, Section 1031 operates to defer recognition of all realized gain. However, if the taxpayer “trades down” and acquires property less valuable than that relinquished — thereby receiving cash or other nonqualifying property in the exchange — like kind exchange status will not be imperiled, but the taxpayer will be forced to recognize some of the realized gain.
Nonqualifying property, or “boot” may consist of (i) cash; (ii) relief from liabilities; (iii) property that could be exchanged under Section 1031, but is not of “like kind” to the relinquished property (e.g., a truck for a horse); or (iv) property expressly excluded from exchange treatment under IRC §1031(a)(2) (e.g., partnership interests).
Realized gain equals the sum of money and the fair market value of property received in the exchange, less the adjusted basis of property transferred. IRC §1001(a); Regs. § 1.1001-1(a). Realized gain is recognized to the extent of the sum of money and the fair market value of nonqualifying property received in the exchange. IRC § 1031(b).
If liabilities associated with the relinquished property are assumed by the other party to the exchange, the taxpayer is deemed to receive cash. IRC §1031(d); Regs. §1.1031(b)-1(c); Coleman v. Com’r, 180 F2d 758. Whether another party to the exchange has assumed a liability of the taxpayer is determined under IRC §357(d).
Although realized gain is recognized to the extent nonqualifying property is received, realized loss with respect to like-kind property relinquished in the exchange is never recognized. IRC §1031(c). However, this does not mean that loss will never be recognized in a like kind exchange. Section 1031 takes a restrictive view of nonqualifying property received in an exchange, since it undermines the purpose of the statute. However, under IRC §1031(c), both gains and losses are recognized with respect to nonqualifying property transferred in a like-kind exchange. Thus, IRC §1031 has no effect on the income tax treatment of nonqualifying property transferred in the exchange.
To illustrate, assume taxpayer exchanges property in Florida which has declined in value, for an oil and gas lease in Montana, and cash. Realized loss with respect to the Florida property is not recognized because loss is not recognized with respect to the transfer of qualifying property. However, if as part of the consideration for the Montana property the taxpayer also transfers Ford stock which has declined in value, realized loss on the Ford stock will be recognized because both gains and losses with respect to the transfer of nonqualifying property in a like-kind exchange are recognized.
As noted, the receipt of cash or other nonqualifying property would normally produce taxable boot to the extent of realized gain. However, Revenue Ruling 72-456 provides that brokerage commissions and perhaps all transaction costs may offset boot. Blatt v. Com’r, T.C. Memo (1994-48) held that expenses incurred in connection with an exchange and not deducted elsewhere on the taxpayer’s return offset boot. Prop. Regs. §1.263(a)-1(c)(2) provide that transaction costs incurred in connection with the sale of property must be capitalized, but those expenses reduce the amount realized. The ABA also endorses this position.
B. Basis Rules
Unlike IRC §121, which excludes realized gain, IRC §1031 operates merely to defer recognition of realized gain. Basis rules under Section 1031 provide the mechanism by which deferred gain is preserved for future recognition the if the replacement property is later sold. (The deferral would, of course, become permanent if the taxpayer dies owning the replacement property, since the basis would then be stepped up to fair market value by virtue of IRC §1014(b).)
IRC §1031(d) and the Regs provide that the basis of property received in a like-kind exchange equals the aggregate basis of property transferred, decreased by (i) cash received; (ii) debt relief associated with the relinquished property; and (iii) loss recognized with respect to the transfer of nonqualifying property. Basis of property received in an exchange is increased by (i) cash or notes transferred; (ii) the adjusted basis of nonqualifying property transferred; (iii) gain recognized on the exchange; and (iv) liabilities associated with the replacement property which are assumed by the taxpayer.
Where non-cash boot is received, basis must be allocated between the replacement property and the boot. Basis is allocated first to nonqualifying property (boot) to the extent of its FMV. Remaining basis is then allocated to nonrecognition properties in proportion to their respective fair market values. The holding period of qualifying property transferred is “tacked” onto the holding period of qualifying like-kind property received in the exchange. However, the holding period of boot received in the exchange begins anew.
To illustrate, assume taxpayer exchanges a building, with an adjusted basis of $500,000, a FMV of $800,000, and subject to a mortgage of $150,000, for consideration consisting of (i) a vacant lot worth $600,000; (ii) $30,000 in cash; and (iii) a Picasso sketch worth $20,000. Realized gain (AR – AB) equals $300,000 [($600,000 + $150,000 + $30,000 + $20,000) – $500,000]. Since debt relief is considered as cash received, $200,000 of nonqualifying property (boot) has been received and will be subject to capital gains tax. The remaining $100,000 of realized gain is deferred. Basis calculations are as follows:
1.Basis of Relinquished Building $500,000
2. Basis Increase: Gain Recognized$200,000
3. Basis Decreases:
a. Money Received $30,000
b. Debt Relief $150,000
Total Basis Decreases $180,000
4. Basis of Relinquished Building $500,000
Plus: Basis Increase $200,000
Minus: Basis Decreases $180,000
Total Basis to be Allocated $520,000
5. Allocation of Basis Allocated Remaining
to be Allocated $520,000
First: To Picasso Sketch
to Extent of FMV $20,000 $500,000
Next: Remainder of
Basis to Land $500,000 -0-
Note: If one year following the exchange the vacant lot which is still worth $600,000 and the Picasso sketch which is still worth $20,000 are both sold, the Picasso sale will produce no gain, but the land sale will generate $100,000 in recognized gain, which corresponds to the deferred gain from the initial sale. (If the Picasso had increased in value and were sold after one year, the sale would produce short-term capital gain, since the holding period for boot begins anew on the date of the exchange. The gain would be short-term because the property was not held for more than one year.)
Where nonqualifying property is transferred in the exchange, the transaction will still constitute a good like-kind exchange, but the consideration received must be allocated between the qualifying property and the nonqualifying property transferred in proportion to their respective fair market values. As noted, consideration allocated to nonqualifying property transferred in the exchange will result in gain or loss recognition under IRC §1001(c); Reg. §1.1031(d)-1(e). No gain or loss is recognized with respect to the transfer of cash, since no “sale or exchange” occurs.
To illustrate basis rules where nonqualifying property is transferred by the taxpayer seeking exchange treatment in a like-kind exchange, consider the taxpayer who exchanges a building, with an adjusted basis of $1 million and a FMV of $1.1 million, plus GM stock with an adjusted basis of $400,000 and a FMV of $200,000, for a vacant lot with a FMV of $1.3 million.
The consideration of $1.3 million is allocated between the building and the GM stock in proportion to their respective fair market values. The taxpayer realizes gain of $100,000 in the building ($1.1 million – $1 million) and recognizes a loss (AB – AR) of $200,000 on the GM stock ($400,000 – $200,000) under IRC §1001(c). The gain realized from the exchange of the building for the vacant lot is not recognized because those properties are of like-kind. The basis of the vacant lot is calculated as follows:
1. Loss on transfer of GM stock
a. Adjusted Basis $400,000
b. Less: amount realized $200,000
c. Loss realized and recognized $200,000
2. Adjusted basis of
relinquished building $1,000,000
Plus: Adjusted basis
of GM stock $400,000
Aggregate basis of
property transferred $1,400,000
3. Aggregate basis of
property transferred $1,400,000
Less: Loss recognized
on GM stock $200,000
Basis of vacant lot $1,200,000
IRC §453 provides that an installment sale is a disposition of property where at least one payment is to be received in the taxable year following the year of disposition. The receipt of an installment obligation will constitute boot, which may be eligible for installment reporting if the taxpayer otherwise qualifies to use the installment method.
Prop. Regs. §1.453-1(f) provide for the timing of gain upon receipt of an installment obligation received in an exchange. The Regs allocate basis in the transferred property entirely to like-kind property received in the exchange. This is disadvantageous, since a greater portion of each payment received under the installment obligation will be subject to current tax.
Relief from liabilities associated with relinquished property may trigger boot gain, or could require the taxpayer to pay cash. For example, if the replacement property is subject to a smaller mortgage than the relinquished property, the net relief from liability will be treated as cash being received in the amount of the net debt relief. This will result not only in boot gain, but will also necessitate payment by the taxpayer of cash to equalize the net disparity in debt among the properties relinquished and replaced. If the taxpayer could prevail upon the seller of the replacement property to increase the mortgage on the replacement property prior to closing, the taxpayer might be able to avoid boot gain. (However, the IRS might still argue that the taxpayer has received boot equal to the cash extracted by the seller of the replacement property, by arguing that in substance, the cash payment the taxpayer is no longer required to pay — and that could easily be extracted tax-free by refinancing after the exchange — is boot.)
Assume the converse situation: The relinquished and replacement properties are of equal value, but the replacement property is subject to a larger mortgage than the relinquished property. If nothing is done, the taxpayer will receive cash to offset the smaller liability associated with the relinquished property. This will result in boot gain. If the taxpayer refinanced the relinquished property prior to the exchange to “even out” the mortgages, the necessity of the taxpayer receiving cash — and therefore the necessity of the taxpayer reporting boot gain — might be avoided.
Fredericks v. Com’r, T.C. Memo 1994-27 posed the scenario described above. Fredericks approved of the pre-exchange financing where it was (i) independent of the exchange; (ii) not conditioned on closing; (iii) dependent on the creditworthiness of the taxpayer, rather than the cash buyer; and (iv) made sufficiently in advance (i.e. “old and cold”) of any contemplated exchange. If these requirements are not met, the IRS may argue that the mortgage was, in substance, obtained by the cash buyer and constitutes taxable boot. Ideally, the taxpayer’s reasons for refinancing should be unrelated to the exchange, and should be motivated, at least in part, by an independent business purpose.
Pre-exchange financing carries with it the risk that the IRS may attempt to recast the cash extracted in the refinancing as taxable boot. Post-exchange financing, in contrast, carries with it much less risk. The differing risk reflects the obligation of the taxpayer vis à vis the loan following the like-kind exchange.
After engaging in pre-exchange financing, the taxpayer will dispose of the property subject to the new mortgage. Since the loan is presumably secured by the real property, the taxpayer’s liability vanishes once the like-kind exchange is consummated. However, the situation with post-exchange financing is different: Here the taxpayer will remain “on the hook” with respect to the financing, since the replacement property will be encumbered. For this reason, little risk is thought to be associated with post-exchange financing.
Some practitioners adhere to the “millisecond” rule, which theorizes that post-exchange financing with respect to the replacement property may be undertaken a “millisecond” after the exchange. More cautious taxpayers will wait until the day following the exchange to complete the financing on the replacement property. In any case, the (i) a different lender should be used for the post-exchange financing; and (ii) no new financing proceeds should appear on the closing statement for the replacement property.
In addition, the taxpayer should not be economically compelled to engage in the post-exchange financing. If the taxpayer would be subject to monetary penalties were he not to proceed with the planned post-exchange financing, the IRS might argue that the cash received in the post-exchange financing actually constituted boot.
The deductibility of interest on refinanced indebtedness depends on the use to which the borrowed funds are placed. In general, interest expense on debt is allocated in the same manner as the debt to which the interest expense relates is allocated. Debt is allocated by tracing disbursements of the debt proceeds to specific expenditures. Temp. Regs. §1.163-8T(a)(3). Property used to secure the debt is immaterial. Temp. Regs. §1.163-8T(c)(1); §1.163-8T(a)(3).
Expenditures are allocated into one of six categories: (i) passive activities; (ii) former passive activities; (iii) investment; (iv) personal; (v) portfolio; and (vi) trade or business. Temp. Regs. §1.163-8T(a)(4)(i)(A)-(E). Thus, the investment of refinancing proceeds in tax-exempt bonds would result in a denial of the interest deduction. Likewise, personal use of refinancing proceeds will result in a complete denial of the interest deduction. The deduction for investment interest is limited to “net investment income.” IRC §163(d)(1). Investment interest does not include interest taken into account under the passive activity loss rules. IRC §163(d)(3)(A), (B). Proceeds of refinanced indebtedness used in an active business are subject to no limitations on deductibility. IRC §163(a).