Discussion:Boot on 1031 Exchange

Question: Is the $750,000 distributed out of the exchange escrow considered as boot?

Here's an example from the regulations. It's from § 1.1031(d)-2, "Treatment of assumption of liabilities".

"Example 2. (a) D, an individual, owns an apartment house. On December 1, 1955, the apartment house owned by D has an adjusted basis in his hands of $100,000, a fair market value of $220,000, but is subject to a mortgage of $80,000. E, an individual, also owns an apartment house. On December 1, 1955, the apartment house owned by E has an adjusted basis of $175,000, a fair market value of $250,000, but is subject to a mortgage of $150,000. On December 1, 1955, D transfers his apartment house to E, receiving in exchange therefore $40,000 in cash and the apartment house owned by E. Each apartment house is transferred subject to the mortgage on it.

(b) D realizes a gain of $120,000 on the exchange.

For purposes of section 1031(b), the amount of other property or money received by D is $40,000. (Consideration received by D in the form of a transfer subject to a liability of $80,000 is offset by consideration given in the form of a receipt of property subject to a $150,000 liability. Thus, only the consideration received in the form of cash, $40,000, is treated as other property or money for purposes of section 1031(b).) Accordingly, under section 1031(b), $40,000 of the $120,000 gain is recognized."

If you remove the $80,000 mortgage on the relinquished property from the IRS example, it seems to me that the example then becomes the same transaction as the OP's question. And since the cash comes out of the exchange escrow, you've got no ability to argue that the taxpayer put the mortgage on the acquired property, rather than assuming it or taking the acquired property subject to it. This leaves the cash received as boot, just as it is in the example from the regulations, and the $750,000 cash received in OP's exchange is therefore taxable boot and will be taxed to the extent of the gain realized in OP's exchange.

Yes, absolutely, and that's a huge planning step in the right direction. Whether it'll be successful depends on how "independent" of the exchange the mortgage can be made. I have a faint memory of Congress - or somebody - proposing a change to the tax law many years ago that would *automatically* bring any mortgage entered into within a couple of years of a like-kind exchange into the exchange, thus making proceeds of the mortgage taxable boot.

I think knowing the subtleties in the tax law and case law and the regs that apply to tax-deferred like-kind exchanges is what makes the experienced tax professional worth his weight in gold. Okay, maybe just silver...

http://www.bayview1031.com/index.jsp?pageId=articleviewer&article=cashoutwithoutboot

Interest-tracing rules would apply even if the loan was valid.

The $750,000 is definitely not boot -- it is debt proceeds. The 124 Front Street decision made it very clear that boot must be derived from the consideration for the exchange -- not from financing activities.

Under the step-transaction doctrine, there is no reason to set up a separate escrow for the $750,000 loan. There is nothing in the 124 Front Street decision that would suggest that the character of the $750,000 loan proceeds would change if the loan were made before, during, or after the exchange.

My answer would change if the Service withdraws its acquiescence on the 124 Front Street decision.

Harry, the difference between the original post and your example is that the cash is coming from a creditor, not from a party to the exchange.

Copyrighted material removed.

Maybe I'm missing something?

However, the RIA discussion is interesting insofar as it does provide insight into avoiding boot treatment upon the receipt of a promissory note which is ordinarily treated as boot when it is received in a 1031 exchange.

Read the 124 Front Street decision. It is right on point.

In any event, the more prudent approach would be to take the exchange not subject to any debt and not pull out any cash as part of the like-kind exchange. If the leverage occurs subsequent to the exchange, the client will have a much better fact pattern.

In North Shore Bus Co, the Second Circuit ruled in 1944 that a taxpayer can receive cash from the other party to the exchange without recognizing boot if the amount is characterized as a loan. I realize that this decision was under the 1939 code; however, it is no less valid under the 1986 code.

The question was answered back when Harry provided the example from Reg § 1.1031(d)-2. Unless, of course, Regs are low on the substantial authority totem pole.

What I am trying to do is argue that a loan is excluded from the definition of “consideration”. For example, if I sell my personal residence for $50,000 and the buyer lends me $100,000 secured by my new residence, is the $100,000 treated as “consideration” for the sale of my old residence?” The answer would depend on whether there is a bona fide loan.

124 Front Street and the Behrens decisions seem to confirm that loan proceeds are not part of “consideration”. IRS apparently agrees with my analysis -- See AOD cited above.

The new property is $250K and the old property was $220K. The exchanger ended up with $40K in cash out of the transaction because he increased the mortgage from $80K to $150K during the exchange. This is crystal clear.

Yes, if we changed the fact pattern in the original post so that my client assumes $750,000 in debt of the original party to the exchange, then the other party to the exchange would be required to write a $750,000 check to my client to equalize equities. In that case, the $750,000 check is coming directly from the other party to the exchange – not from a third-party lender.

Example 2 of Regulation § 1.1031(d)-2 doesn’t apply to the original post since my client is not taking property subject to an existing mortgage.

I would never recommend transferring $1 million in equity in real estate while receiving in return only $250,000 in equity in replacement real estate. This would automatically cause $750,000 in boot. Presumably, the safest route to take would be to avoid using a QI.

Remember, your client is using a QI to facilitate an exchange. When the QI assigns the replacement property to your client with the new mortgage and releases that $750K of sales proceeds from the exchange funds, it is the exact same transaction as the example in the Reg.

I am in full agreement that if a QI is used and the QI is named on the mortgage, there could be a real problem with this scenario.

 Slam. Dunk. Cut. Dried. 

In 124 Front Street, someone mentioned earlier in this thread that the taxpayer did receive $40,000 cash and it was boot and he did get taxed on it. That's what happens when an exchanger gets to keep cash from an exchange.

What is it about the three quarters of million dollars of cash in the OP's scenario that makes it *not* unlike-kind property and therefore boot? I'm reading and listening and haven't heard anything convincing.

The impression I'm getting is that in Front Street the taxpayer was advanced some money by the other party to the exchange and then wasn't taxed on that money to the extent he didn't have it, after the exchange. Which is not the case here. OP's taxpayer gets to keep the $750K.

I don't subscribe to RIA but I would like to read the case and/or the AOD. Is either available online?

UIL No. 1031.01-00; 0061.00-00 Headnote:

Reference(s): Code Sec. 61; Code Sec. 1031; Full Text:

CC:TC:T1

PPlourde IN RE: 124 FRONT STREET, INC.

65 T.C. 6

Venue: C.A. 9th

Docket No. 1229-74

Dec.: November 26, 1975

Opinion: 65 T.C. No. 2 Tax, Year and Amount

         Deficiency
         Determined          Redetermined

Year Income Tax Penalty Income Tax Penalty 1970 $242,352.00 $12,118.00 $22,140.91 ---

ISSUES

   1. Whether the transaction between petitioner and Firemen's Insurance Company of New Jersey (hereinafter Firemen's) represents a sale of petitioner's option to purchase 124 Front Street (hereinafter Front property) or whether it represents an exchange of properties within the purview of Internal Revenue Code of 1954 , §1031 (hereinafter cited as Code ). (1031.01-00) 
   2. Assuming the above transaction to be an exchange within Code § 1031, whether the funds deposited by Firemen's into an escrow account to enable the petitioner to acquire the Front property was boot or a loan. (0061.00-00) 

DISCUSSION

On August 1, 1969, Firemen's contracted to purchase the Front property from petitioner for either $1,025,000 or for exchange property to be designated by petitioner in lieu of cash. The petitioner on that date held merely an option, exercisable in 1974, to purchase the Front property for $200,000. As a result of prior negotiations, however, the petitioner could acquire the Front property for $425,000. Because the petitioner did not have the necessary funds, Firemen's deposited $425,000 into an escrow account to enable the petitioner to acquire the Front property. Thereafter, petitioner elected pursuant to the August 1, 1969 agreement to transfer title to the Front property for property located at 240 Stockton Street (hereinafter Stockton property). On February 16, 1970, the Stockton property was transferred to the petitioner for the Front property.

   1. Respondent's primary argument was that petitioner merely relinquished an option to purchase the Front property in return for ownership of the Stockton property and, thus, petitioner must recognize capital gain on the 1970 transaction. The Tax Court held, however, that the transaction represented a valid exchange of property. Essentially, the court determined that the structure of the transaction, as evidenced by a series of legal documents, was consistent with the intent of the parties to sell or exchange the Front property after petitioner exercised the option 

The difference in result turns on whether the transaction between petitioner and Firemen's should be viewed in its entirety of in individual, component steps. Viewing the transaction in its entirety, as advanced by respondent, is erroneous because the critical point is the date of exchange as distinguished from the date of the exchange agreement. Specifically, Rev. Rul. 75-291, 1975-29 I.R.B. 18 which involved a taxpayer who did not own the exchanged property at the time of entering into an exchange agreement did not equalify for nonrecognition of gain or loss under Code § 1031 because the taxpayer acquired the property transferred immediately prior to the exchange and did not hold such property for productive use in its trade or business or for investment. Irrespective of whether the property is owned or whether the taxpayer has a mere option on the date of the exchange agreement, therefore, the focus is upon the exchanged property to determine if it was held for the prescribed purposes.

Instead of arguing that a taxpayer merely relinquished an option in return for ownership of other property, similar cases in the future should focus on whether the property was held for the prescribed purposes. Notwithstanding that such determination is premised on all the facts surrounding the acquisition and holding of the exchanged property, the establishment of a prearranged plan to exchange must be emphasized. Specifically, any purported holding of the exchanged property for the prescribed purposes is vitiated by the presence of a prearranged plan to exchange prior to the acquisition of the exchanged property.

   2. Respondent advanced in the alternative that the $425,000 deposit constituted boot on the exchange of the Front property for the Stockton property in 1970. The Tax Court held, however, that such deposit was a loan. Because there is record evidence to support the Court's factual finding, it is not clearly erroneous. 

RECOMMENDATION

   1. Nonacquiescence and no appeal. 
   2. Acquiescence.

(D $40K cash plus FMV$250K-less negative mtge relief/assumption of $70K) versus E's total consideration rec'd of $250K (FMV $220 less $40K cash given plus net mtge relief of $70K). Unless of course the appraiser of the FMV of D's bldg given up should have been $30K less or $190K, in which case both D's & E's recognized gains would still be $40 & $30K respectively. Would IRS think some hanky panky was going on if this were a real life case. I found this a good exercise. To go one exercise further, it would seem that the FMV of the bldg given up by B in example 1 would have to be $1,000,000?

Well, I saw the sand kicked up by the receiver's foot...!! On *two* replays...!!

As has been stated several times in this thread, the transaction in the OP does not look at all like 124 Front Street. In that case, the exchanger received the loan in order to purchase the property--separate transaction. The exchanger then later relinquished that property in another transacation.

Furthermore, it confuses me how can you say that this would be boot if the exchange was conducted within a deferred exchange via a QI, but it would not be boot in this simultaneous exchange. Reg § 1.1031(d)-2 "Treatment of assumption of liabilities" does not have separate rules for simultaneous exchanges and deferred exchanges.

A loan assumed from the QI is not the same as a direct loan from the lender. Reg example 2 applies only to exchanges where the property is taken subject to an existing loan.

Note the word "existing" in the last sentence of Jack's post, above. (Also, note that this word is not included in the Reg example.)

Note the word "new" in the OP: Taxpayer is exchanging an apartment building worth $1 million for another apartment building worth $1 million. The relinquished property is debt-free. However, the new property will have a new loan of $750,000. Consequently, the client will pull $750,000 in cash out of the exchange escrow.

Is this what is being debated? Since the loan is a new loan being obtained for the purchase of the replacement property, are you all saying that this is a case where there is no boot?

I am still in disagreement, but this will help us, at least, isolate the issue.

On the other hand, if the client receives a $750,000 check from Citibank, there is no boot. This would be true under the 1956 regs, the 1967 regs, and the 1991 regs. There is nothing in those regulations that would require the client to set up a separate loan escrow to avoid boot treatment of loan proceeds.

If the mortgage is taken out by the QI prior to the transfer of the replacement property, then obviously, there would be boot since the QI will be writing the $750,000 check. However, if the mortgage is taken out after the QI has transferred the replacement property to the client, then there would be no boot since the QI will not have access or control over the $750,000.

The obvious solution is to avoid using a QI. Remember that the use of the QI safe harbor is not really necessary in the case of a simultaneous exchange.

In the Front Street case, the taxpayer didn't get to keep the $425,000 loan, it was an advance, and got used up in the exchange. In OP's exchange, the $750,000 still belongs to the taxpayer "at the end of the day" when the exchange is finished. Uh... does anybody else see this distinction?

The OP also has the taxpayer receing a property subject to mortgage at close of escrow. Sure! This is a new mortgage, but that property is being transferred subject to this mortgage. And as a result, the taxpayer also ends up with cash in his hand.

Petitioner contends that the no-netting rule of Coleman, supra, and section 1.1031(d)-2, Example (2)(c) should not apply to him because he did not assume a pre-existing liability, but incurred a newly created debt in connection with his exchange transaction. The regulations speak only in terms of assuming a liability, not of assuming a pre-existing liability. See n. 12, supra. Petitioner cites and we have found no authority permitting the netting of cash received against consideration given by taking property subject to a liability based on the liability being newly created rather than pre-existing. Petitioner also seems to argue that because the new debt was newly created the $22,080.37 cash should be treated as a loan and not as boot. Petitioner has not suggested and we cannot think of any reason why that should be the case. If the boot provision of section 1031(b) and the limited boot-netting permitted under the regulations could be circumvented by a simple device of creating new debt rather than continuing old debt, then cash consideration would never be boot. If that were the case, any taxpayer could cash-out portions of his equity in any exchange transaction without triggering recognition of any gain. We do not think that is the rule under the statute, regulations, or case law.

Also

Unlike petitioner, the taxpayer in 124 Front Street, Inc. did not retain any part of the $425,000 for his own use and the cash did not reduce the taxpayer's net investment in the like-kind properties exchanged. Here, the cash petitioner received did reduce his net investment in the truck tractors.

If petitioner had borrowed the money from a third-party lender, he would have received the cash in a nontaxable event: the borrowing of money. But petitioner actually obtained the $22,080.37 through an exchange of property. Such a transaction usually triggers the recognition of gain, sec. 1001(c), but may not if the requirements of section 1031(a) are met. One of those requirements is that property be exchanged solely for property of like kind. This "solely" requirement precludes nonrecognition of gain under section 1031(a) where the taxpayer exits the exchange with money resulting from a liquidation of part of his net equity in the property exchanged, which petitioner did. Thus, the fact that petitioner could have reduced his net equity in his truck tractors before or after the trade-in through a nontaxable loan (and thereby avoided any adverse tax consequences thereform) neither conflicts with nor derogates from our holding. It simply did not happen. Petitioner's liquidation of a part of his net equity in his truck tractors through the exchange places the transaction under section 1031(b) and petitioner's gain must be recognized to the extent of the $22,080.37.

Footnote 13

This analysis of "what could have been" assumes that the loan and exchange transactions would have been respected for tax purposes and not collapsed under the step transaction doctrine. For a classic application of the step transaction doctrine, see Gregory v. Helvering, 293 U.S. 465 [14 AFTR 1191] (1935).

The Behrens case involved the transfer of $15,800 of his $37,880.37 equity to International Harvester. He then received $22,080.37 from International Harvester, which constitutes boot.

The original post is completely different. The taxpayer transferred $1 million in equity to the other party to the exchange, then received $1 million in equity from the other party to the exchange. The $750,000 refinance was done through a third-party lender and was not received from the other party to the exchange.

Furthermore, this case concentrates on the fact that the Petitioner is exiting the exchange with cash through a liquidation of his equity investment in like-kind property, same as the OP. The source of that cash is not the issue.