Financing Issues

"A newsletter devoted to the education of those involved in section 1031 exchanges"

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HOT ISSUES IN 1031 EXCHANGES

Representing real estate owners often involves planning for the sale of property. More often than not, financing issues will be involved. When the transaction also involves a like-kind exchange, the tax advisor needs to be aware of the interrelationship between the 1031 rules and the financing of real estate.

FINANCING ISSUES AND IRC § 1031 LIKE KIND EXCHANGES

"Having Your Cake And Eating It Too"

Most taxpayers look forward to paying taxes about as much as a trip to the dentist. It is not surprising, therefore, that owners of investment property are sweet on IRC § 1031, which provides that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of a like-kind which is to be held for productive use in a trade or business or for investment."

Although deferral of gain is a good thing, some taxpayers want more. They want to tap into the equity in their investment property, either before, after, or simultaneously with the exchange. Historically, the issue has been whether the taxpayer who dips into the honey pot via a refinancing either before, after, or simultaneously with the exchange will be treated as receiving "boot" and subsequently stung by the IRS.

The following first examines the issue concerning liabilities in a like-kind exchange, and a recent private letter ruling clarifying a technical problem with the same. The remainder examines timing issues for the taxpayer who desires to tap into the equity in the investment property.

1. The Rules - Liability Netting

A taxpayer engaging in an otherwise valid like kind exchange will recognize gain if "boot" is received. Boot includes cash and the fair market value of any property other than qualifying like-kind property. Boot also includes any liabilities transferred by the taxpayer to the other party, provided, however, if the taxpayer also acquires a liability on the property received, the liabilities are netted, and the party that is relieved of the greater liability has taxable boot equal to the excess.

In today's market, most liabilities are extinguished at the time of the sale of the taxpayer's relinquished property because the buyer's lender requires the same as a condition to its making of the loan. This creates a problem for the exchanging taxpayer because if he is required to accept payment for his relinquished property and to simultaneously pay off the existing encumbrance, the IRS could argue that the taxpayer had constructive receipt of the sales proceeds, thereby invalidating the exchange. Accordingly, most exchanges involve the use of a qualified intermediary to hold the receipt of funds, net of the liabilities, and to avoid the constructive receipt rules.

The following is an example of a typical exchange handled by All States 1031 Exchange. Taxpayer desires to sell an apartment building with a tax basis of $100,000, a fair market value of $400,000, and encumbered by a mortgage of $100,000. The purchase and sale agreement requires that the property be transferred free and clear of existing mortgages. The buyer does not wish to enter into a simultaneous 1031 exchange. All States 1031 Exchange is hired to serve as the qualified intermediary. The buyer transfers the $400,000 purchase price to All States 1031 Exchange, and the loan is retired. Taxpayer identifies a strip mall with a fair market value of $500,000. Using a portion of the remaining $300,000 exchange proceeds from the sale of the relinquished property, All States 1031 Exchange makes a down payment on the replacement property and the taxpayer arranges for a $200,000 mortgage to finance the remaining portion of the purchase price.

The problem with the above scenario is that the buyer of the relinquished property did not assume the taxpayer's existing indebtedness on the replacement property. Similarly, the taxpayer did not actually assume a mortgage on the strip mall, nor take the strip mall subject to any mortgage. Rather a new mortgage was obtained, one that was $100,000 greater than the one retired on the relinquished property. The issue has always been whether the mortgages can be netted, or whether the taxpayer is considered in receipt of taxable boot equal to the mortgage on the relinquished property retired with the proceeds generated from the sale of the relinquished property.

In a recent ruling, PLR 9853028, the IRS held that the liabilities as described in the preceding scenario should be netted. In the taxpayer's case, then, he is treated as having "assumed" a greater liability by $100,000, as his new mortgage of $200,000 exceeded the $100,000 mortgage that was retired. Accordingly, taxpayer has no taxable boot.

2. Timing Issues - Refinancing

The issue created by refinancings is whether proceeds received by a taxpayer which exceed existing debt encumbering relinquished property prior to an exchange or debt encumbering replacement property immediately following an exchange constitute boot. The analysis is somewhat different for pre-exchange and post-exchange refinancings.

a. Refinancing after the exchange

As a general rule, a taxpayer does not incur any tax liability when debt is incurred. Is there a problem if the debt is incurred in connection with the receipt of replacement property in a like-kind exchange? The concern has been whether a 1031 exchange followed by the receipt of debt proceeds would be viewed as the functional equivalent of the receipt of boot by the taxpayer. Out of an abundance of caution, many tax professionals have advised their clients to wait a period of time (one or two months sometimes even one or two years) before encumbering the replacement property.

There is no judicial or legislative reason, nor has the IRS stated a position, why a taxpayer cannot encumber the replacement property after the exchange, and there is no valid reason why the taxpayer should wait before encumbering the same. The receipt of debt proceeds from a refinancing does not give rise to taxable income, and the fact that the debt proceeds are from replacement property obtained in a like-kind exchange should not alter this result.

The key to the distinction between pre- and post-exchange refinancings is that the taxpayer will remain responsible for repaying a post-exchange replacement property refinancing following completion of the exchange whereas the taxpayer by definition will be relieved from the liability for a pre-exchange relinquished property refinancing upon transfer of the relinquished property. A fundamental reason why borrowing money does not create income is that the money has to be repaid and therefore does not constitute a net increase in wealth. This is clearly the case in a post-exchange refinancing and there is no analytic reason to characterize such financings as being in lieu of fictitious payments by the seller of replacement property. Accordingly, the taxpayer can defer the recognition of gains tax on the exchange, and immediately thereafter tap into the equity in the replacement property, placing cash in his pocket.

b. Refinancing before the exchange

Existing judicial authority indicates that where a pre-exchange refinancing is completed as part of an integrated transaction which includes the exchange, cash received by a taxpayer from a lender will be treated as cash received on disposition of the relinquished property. Assume that A is transferring unencumbered Property 1 (worth $200X) in an exchange with B, who will transfer encumbered Property 2 (worth $200X, encumbered by a $100X mortgage). As part of the exchange, but immediately prior to conveying title to Property 1, A obtains a new $100X loan secured by Property 1. A and B exchange and each takes subject to (or assumes) the loans encumbering the properties. In effect A has "cashed out" in the amount of $100X, but if the rules of Reg. section 1.1031(b)-1(c) are strictly construed, A has recognized no gain since A took Property 2 subject to debt which equaled the debt relief obtained.

Notwithstanding this apparent rule, the Service is likely to assert that A has recognized gain of $100X because the cash received from the refinancing should be viewed as part of the consideration given by B on acquisition of Property 1. This principle is sometimes referred to as the "in anticipation of exchange" concept. The Service attempted formally to include this concept in the Section 1031 regulations by proposing an amendment to Reg. section 1.1031(b)-1(c) in 1990 and referring to this as a clarification of existing law. However, protests from practitioners and the public led the Service to conclude the proposed rule "could create substantial uncertainty in the tax results of exchanges." The proposal was withdrawn in the final regulations adopted in 1991. Although the proposal was withdrawn, the Service has not formally stated whether it still adheres to the proposition.

The key distinction should be whether the taxpayer ever bore the risk of repayment of a debt so as to permit the normal non-realization treatment of refinancing transactions. If the debt "came to rest," i.e., became the taxpayer's liability for more than the time needed to close subsequent parts of an exchange, then the usual non-realization treatment should apply and the existing boot-netting rules should apply to the debt. Thus, "true" refinanced debt will be offset either by debt assumed or taken subject to or by cash paid by the taxpayer. From the taxpayer's perspective, this means that refinancings should occur as separate, independent transactions from the exchange.

c. Refinancing simultaneously with the exchange

(i) Relinquished Property

As stated above, the IRS has exhibited hostility to pre-exchange refinancings. A refinancing occurring contemporaneously with the sale of the relinquished property, besides being commercially impracticable, would be subject to a high level of scrutiny especially since it is doubtful that the debt "came to rest."

(ii) Replacement Property

The exchange boot rules provide that "if the taxpayer receives other property (in addition to property permitted to be received without recognition of gain) or money--[i]n an exchange described in section 1031(a) of property held for investment or productive use in trade or business for property of like kind to be held either for productive use or for investment...the gain, if any, to the taxpayer will be recognized under section 1031(b) in an amount not in excess of the sum of the money and the fair market value of the other property, but the loss, if any, to the taxpayer from such an exchange will not be recognized under section 1031(c) to any extent." Some tax advisors have read into this regulation the conclusion that cash received from a new financing secured by the replacement property and incurred by taxpayer simultaneously with the exchange is boot. This concern, however, is misplaced. Although the loan may fund simultaneously with the exchange, the loan is independent of the exchange and should not be considered money "from such an exchange." It is also significant that the taxpayer will have to repay the loan when due. The taxpayer should not be taxable on borrowed money it will have to repay.

3. Planning Points

The IRS has shown a willingness to recognize the commercial reality of today's real estate market and does not insist upon a strict interpretation of the liability netting rules of Section 1031. This means that a taxpayer desiring to sell encumbered property need not find a buyer willing to assume the existing indebtedness. In general, the taxpayer will not recognize gain if he or she utilizes a qualified intermediary (to avoid constructive receipt issues), if the replacement property has equity equal to or greater than the equity in the relinquished property, and if the liabilities secured by the replacement property are equal or greater than the liabilities secured by the relinquished property.

If the taxpayer requires cash and is looking to obtain the same from the exchange property, he or she is safer borrowing from the replacement property. The reason for this is that the IRS has shown hostility to a taxpayer incurring new liabilities on the relinquished property in anticipation of an exchange. The cash hungry taxpayer, however, can have his cake by avoiding the recognition of gain through a like-kind exchange, then eat it too by refinancing the replacement property immediately thereafter.