Taking Off an Old Boot
By Business & Taxation Practice Group
SAALFELD GRIGGS PC
Every taxpayer’s goal is to defer taxes as long as he or she can. Like-kind exchanges under Section 1031 of the Internal Revenue Code are one way to accomplish this. When a taxpayer owns property that is held in a trade or business or for investment purposes and exchanges it for like-kind property, also called replacement property, no gain or loss will be recognized.
However, as a general rule, if a taxpayer receives cash or other non-like-kind property in a like-kind exchange transaction, the cash or value of the other property is called boot and will be taxable. This can happen when the property that is being exchanged is worth more than the replacement property.
With a little planning, a taxpayer can have their cash and receive deferral too. The safest approach for a taxpayer who wishes to defer tax on an exchange, while receiving some cash, is to simply borrow against the replacement property after the exchange is completed. A taxpayer does not incur any form of taxation merely because they have borrowed against property that they own. This rule applies even if debt is placed on re-placement property immediately following the like-kind exchange.
Although an immediate borrowing against replacement property is essentially equivalent to receiving boot in an exchange transaction, there is no legal authority that would support the imposition of a tax on a person who immediately encumbers replacement property received in an exchange. However, care should be taken in the drafting of loan and escrow documents to clarify the source of the cash as loan proceeds, not boot. A more cautious approach would be for the taxpayer to wait for some period of time before encumbering the replacement property, but most commentators would suggest that no waiting period is required.
If the taxpayer needs cash before the proposed exchange can be consummated, he or she may obtain a loan on the relinquished property. Although there is greater risk in this situation, so long as the debt which encumbers the replacement property is equal to or greater than the debt on the relinquished property, the mere fact that money is borrowed against the relinquished property prior to the exchange should not cause the loan proceeds to become taxable. Again, the safer course would be to obtain the loan on the relinquished property some time before the exchange transaction closes. The use of a separate escrow for the loan closing is advisable.
Interestingly, the IRS has issued an adverse ruling in a situation where a taxpayer borrowed cash immediately before an exchange was completed. Nonetheless, the legal foundation for this ruling is questionable. The general regulatory provisions would permit a taxpayer to net liabilities on the replacement property against the debt which encumbers the relinquished property. If the debt on the replacement property equals or exceeds the debt on the relinquished property, then there should be no adverse tax consequences to the transferor as a result of the receipt of loan proceeds on the relinquished property.
To illustrate, let’s assume that the taxpayer owns certain land as investment property. The property is worth $180,000. There are no encumbrances on the property. The taxpayer wants to exchange this property for replacement property that is worth $190,000 and is encumbered by a $40,000 mortgage. Normally, in a like-kind exchange, the taxpayer would be paid $30,000 in boot. That boot is taxable. If, however, prior to the 1031 exchange, the taxpayer borrows $30,000 on his investment property, leaving an equity of $150,000, and then does the exchange, there should be no taxable boot.
In summary, with careful planning and borrowed funds, a taxpayer can participate in an exchange and have the benefit of current cash without an immediate tax. The structure of the loan and exchange documents would be crucial to achieving the desired result in this area.