Circular 230 disclosure: Any tax advice herein is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code.
Boot may take many forms, but a common thread is that boot always refers to nonqualifying property received in an exchange. Boot will not take an otherwise qualifying exchange out of Section 1031. However, boot will generate taxable gain to the extent of realized gain. Put another way, realized gain will be recognized (reported) to the extent of boot. Thus, in an exchange where realized gain is $20 and $10 of boot is received, a good exchange may occur, but the taxpayer will report $10 of gain. The most common types of boot are cash and “mortgage” boot. Mortgage boot arises where the taxpayer is relieved of more liabilities in the exchange than he assumes.
The IRS does not appear to require the taxpayer to report boot gain merely because a mortgage is paid off at the closing of the relinquished property, provided the replacement property (acquired later) carries as much debt as that which was extinguished at the first leg of the exchange. Boot “netting” rules articulated in the Regulations provide that (i) infusions of cash by the taxpayer into the exchange will offset debt relief, but (ii) the receipt of cash will not offset new debt incurred in the exchange. The rationale clearly appears to be that Section 1031 simply cannot countenance the receipt by the taxpayer of cash in an exchange, even if new liabilities are incurred. On the other hand, sensibly, if the taxpayer invests more cash, then that should offset liabilities with respect to which the taxpayer was relieved in the exchange. The distinction is nuanced, but significant.
Boot may also take other forms, each of which may result in taxable gain. For example, boot may consist of property expressly excluded from like kind exchange treatment under IRC §1031(a)(e.g., partnership interests) or simply property which is not of like kind to the relinquished property (e.g., a truck for a horse). Even if no nonqualifying property is received in the exchange, the IRS has taken the position that an exchange of real estate whose values are not approximately equal may yield boot. See PLR 9535028. This could occur, for example, in a situation involving the exchange of property among beneficiaries during the administration of an estate. The taxpayer must always be vigilant to a potential IRS challenge, which could in a relatively bad case scenario lead to boot gain, and in a worst case scenario imperil exchange treatment itself. The taxpayer should be aware of the following risk areas when structuring a like kind exchange:
(i) where the taxpayer ends up with cash in his pocket after the exchange, even if the receipt of cash is indirect or related to refinancing;
(ii) where related parties are involved, especially where “basis shifting” occurs and cash “leaves” the group of related parties;
(iii) where the transaction is not “old and cold” and lacks a substantial business purpose other than tax savings, especially in pre-exchange refinancing;
(iv) where the end result of the transaction (or series of transactions) could have been more easily accomplished in a simpler way and it appears that tax avoidance played a part in the decision to structure the transaction as it was;
(v) where properties are at risk of being identified by the IRS as not being of “like kind”;
(vi) where the taxpayer has not “held” either the relinquished property or the replacement property for productive use in a trade or business or for investment for a sufficient period of time before or after the exchange; or
(vii) where partnership interests are involved, directly or indirectly. Given the myriad of contexts in which boot can arise in an exchange — and keeping in mind the risks associated with exchanges — it is appropriate to consider strategies that may avoid mistakes that could result in boot gain.
Plan the exchange in advance. The 45-day identification period elapses quickly. While no identification is necessary if closing occurs within 45 days, it is always preferable to identify backup property in the event closing cannot occur within 45 days. It is perfectly acceptable to identify properties for which a deposit has already been made, or a firm intention to commit has been communicated.
Consider an “exchange last” reverse exchange if the choice of replacement property is clear, but uncertainty exists as to which property (or properties) is or are to be relinquished. An exchange last reverse exchange will permit the taxpayer’s accommodator (“EAT”) to actually acquire replacement property on the taxpayer’s behalf, and hold it for up to 180 days. The taxpayer must identify property to be relinquished within 45 days, and close on that relinquished property within 180 days.
Consider an “exchange first” reverse exchange where the choice of relinquished and replacement properties are clear, but no buyer has been found for replacement property. This may occur where the buyer of the intended relinquished property defaults and the taxpayer is already committed to replacement property. In an exchange first reverse exchange, the taxpayer immediately takes title to desired replacement property. An accommodator (“EAT”) purchases the taxpayer’s relinquished property and parks it for up to 180 days, until the taxpayer finds a new buyer. Although more complex and costly than deferred exchanges, reverse exchanges can preserve exchanges that might otherwise fail.
Consider approaching an accommodation party if the 45-day identification period becomes problematic. If suitable property cannot be identified within the 45-day identification period, consider approaching a party who may already own potential replacement property. If an unrelated party cannot be found, consider approaching a related party. Provided there is no cash leaving the group, and no basis shifting occurs, the related party may be viewed as merely an accommodation party. Provided no tax avoidance purpose is present, the exchange may proceed, with the proviso that neither related party may dispose of any property either party acquires in the exchange within 2 years. Note that the 2-year period applies to the related party accommodating the taxpayer, even though the related party is not seeking exchange treatment.
Make full use of the identification rules. The identification rules allow the taxpayer a choice of identifying (i) up to three properties, regardless of their respective fair market values; (ii) any number of properties, provided their aggregate fair market value does not exceed 200 percent of the fair market value of the relinquished property; (iii) any number of properties the taxpayer actually closes on within the 45-day identification period; or if risk is acceptable (iv) any number of properties, provided the taxpayer actually closes on properties the fair market value of which equal or exceed 95 percent of the fair market value of properties identified. Note: Rule (iv) is risky since the failure to satisfy the 95 percent requirement will result in the entire transaction becoming taxable.
Avoid constructive receipt of cash. Once a sale has occurred, reversing the tax consequences of the receipt of cash, either actually or constructively, may be nearly impossible. Use of safe harbors provided in the regulations are effective in avoiding constructive receipt or agency. Constructive receipt may occur where money or other property is set apart for the taxpayer, or otherwise made available to him. However, the taxpayer is not in constructive receipt of money or other property if the taxpayer’s control is subject to substantial limitations. IRC §446; Regs. §1.446-1(c).
Avoid receipt of cash when exchanging into leveraged property. t may be possible to request that the cash seller use cash to pay down the seller’s mortgage instead of the taxpayer receiving cash in the exchange. However, this should be done well in advance of the closing and must satisfy strict case law and IRS ruling requirements. This is an area where a ruling request may be advisable.
Some cash received may not constitute boot. Cash payments received by the taxpayer with respect to which the taxpayer is contractually bound to use to pay down a mortgage associated with the replacement property may not be considered boot. Barker v. Com’r, 74 TC 555.
Receipt of some loan repayments may not constitute boot. Loans made by the taxpayer related to the acquisition of replacement property may be repaid without being considered taxable boot.
Borrow from relinquished property prior to exchange. The taxpayer may extract cash tax-free prior to an exchange provided the mortgage is (i) unrelated to the exchange; (ii) “old and cold”; and (iii) has a legitimate business purpose. Fredericks v. Com’r, T.C. Memo 1994-27.
Borrow from replacement property following exchange. Since the taxpayer will remain liable on the borrowing following an exchange, there is less risk that the IRS will challenge the a new mortgage taken on the replacement property. Borrowing on the replacement property should take place after the closing.
Consider separating multiple asset exchanges. Multiple asset exchanges may result in boot gain, even where no cash is received. It may be possible to separate multiple asset exchanges to avoid this adverse result. However, the IRS may interpose the step transaction doctrine where the exchanges the transaction appears to take the form which it did to achieve a favorable tax result.
Avoid the Step Transaction Doctrine. As a practical matter, where sufficient time has elapsed between steps in a transaction, the IRS will be less successful in interposing the “form over substance” argument. Of course, time is often a luxury that the taxpayer engaged in an exchange cannot afford. The step transaction doctrine may be interposed where a transaction appears needlessly complex. Nevertheless, a taxpayer is faced with two methods of achieving the same resultis not compelled to choose the method that will result in the most tax for the government. Gregory v. Helvering, 69 F.2d 809 (2d Cir. 1934, aff’d, 55 S.Ct. 266 (1935)).
Consider using escrows at closing to avoid boot or to receive cash. If transactional boot in the form of credits issued by the taxpayer at closing would result in boot gain, the taxpayer might consider placing funds (e.g., unearned rent) in escrow prior to the closing and refunding the cash to the buyer at closing. On the other hand, if transactional boot is not a problem, the taxpayer might consider taking cash at the closing of the replacement property. For example, instead of receiving a credit for prorated rent retained by the cash seller, the taxpayer may prefer to receive cash. However, there appears to be no IRS authority for this position.
Consider the use of installment sales to defer boot gain that must be recognized. If gain must be recognized, installment sales under IRC §453 will at least accomplish deferral. However, this will result in further complexity, as either the relinquished property or other property must secure the promissory note. Where an exchange fails, provided the taxpayer had a bona fide intent to engage in an exchange at the beginning of the exchange period, installment reporting may be available and useful to avoid immediate gain recognition.
Beware of the related party rules. Use of a qualified intermediary will not result in the avoidance of these rules. If cash “leaves” the group, and basis shifting occurs, in most cases the IRS will object. Recent cases suggest that where these two negative incidents appear, boot gain will result almost as a matter of law.