Andy Gustafson

Typically the taxpayer closes on their investment property before closing the new replacement property and a traditional forward 1031 tax exchange would be completed. Of course, that’s not always the case, especially when the housing market is improving, and in many areas of the country, multiple offers are received within days of listing. In 2000, the IRS enacted Revenue Procedure 2000-37, providing the guidelines for which the taxpayer may complete a 1031 reverse exchange.  A reverse exchange is when the replacement is acquired before selling the relinquished or old property.

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When a taxpayer sells real property, any gain realized on that sale is potentially subject to the payment of federal and state capital gains and recaptured depreciation taxes.  The rate at which capital gains are taxed is typically high, taxpayers often turn to alternative methods of acquiring property to avoid the payment of those taxes. One such method is through a Section 1031 Exchange of property. Any potential capital gains and depreciation recapture taxes that would otherwise be due are deferred if a transaction qualifies for Section 1031 Exchange status. At its most basic, a Section 1031 Exchange contemplates a taxpayer relinquishing one property and replacing it with another property of “like-kind.” Often, however, Section 1031 Exchanges are far more complicated than a simple exchange. Numerous issues come into play that can impact whether or not a transaction qualifies for Section 1031 treatment. One of those issues is the existence of “boot.”

Mortgage and Equity Boot

One of the basic premises of a Section 1031 Exchange transaction is that the taxpayer does not actually receive compensation for the relinquished property at any time during the transaction. A Qualified Intermediary, or QI, is used to facilitate the exchange, drafting documents and holding exchange funds on behalf of the taxpayer. If the property to be relinquished and the replacement property are of equal value, the exchange is easily completed. For numerous potential reasons, however, a Section 1031 Exchange may result in excess cash after the transaction is completed. If a transaction does net cash, or other compensation such as debt that is not replaced, it is referred to as “boot”. Any net boot remaining after a Section 1031 Exchange is completed is potentially taxable as capital gains.

What if the “boot” is used to pay off liabilities of the taxpayer as part of the transaction? Barker v. Commissioner of Internal Revenue, 74 T.C. 555, 1980 WL 4456 (1980) addressed that question. In a multiple-party 1031 Exchange agreement, boot was used to pay off mortgage liabilities of the taxpayer. In that case, the Tax Court held that:

“… boot-netting is permissible in a case where, contemporaneously with the exchange of properties and where clearly required by the contractual arrangement between the parties, cash is advanced by the transferee…to enable the transferor-taxpayer (petitioner) to pay off a mortgage on the property to be transferred by the taxpayer.”

The key in the Barker case was that the parties were contractually obligated to pay off the liabilities, meaning that the taxpayer did not have the option to simply take the cash and walk away from the transaction. For this reason, the Court did not find the “boot” to be taxable.

The Internal Revenue Code Section 1.1031(j)-1 provides specific instructions for exchanges involving multiple properties. For a taxpayer contemplating the payoff of secured or unsecured debt as part of a Section 1031 Exchange agreement, the code states:

“All liabilities assumed by the taxpayer as part of the exchange are offset against all liabilities of which the taxpayer is relieved as part of the exchange, regardless of whether the liabilities are recourse or nonrecourse and regardless of whether the liabilities are secured by or otherwise relate to specific property transferred or received as part of the exchange.”

In summary, both the IRS code and case law make it clear that paying off liabilities can be part of a Section 1031 Exchange; however, the payoff must be carefully structured and the parties must be contractually obligated to pay off the liability to avoid incurring taxable boot. There is no requirement that debt must be secured by the property. Given the debt is “traceable to the property” may be sufficient. At best, the taxpayer can use exchange proceeds to repay debt as liability relief boot offset in the form of liabilities assumed or additional cash paid on the replacement property.

Download four questions to ask a Qualified Intermediary when vetting a QI to accommodate your exchange.

Fundamental to a 1031 exchange is the requirement that the replacement property be held as an investment property; not as a second home. The property can be converted to a second home, but only after it is first held as an investment. Often loan and deed of trust documents reflect a second home rider clause stating the property cannot be rented out or placed in a rental pool. Caution, beware, “Houston we have a problem” or at least discuss with your financial advisor. Continue reading to recognize whether your Deed of Trust contains a Second Home Rider typically found at the end of the loan agreement.

Second Home Rider

“Occupancy. Borrower shall occupy, and shall only use, the Property as Borrower’s second home. Borrower shall keep the property available for Borrower’s exclusive use and enjoyment at all times, and shall not subject Property to any timesharing or other shared ownership arrangement or to any rental pool or agreement that requires Borrower either to rent the Property or give a management firm or any other person any control over the occupancy or use of the Property.

Borrower’s Loan Application. Borrower shall be in default if, during the Loan application process, Borrower or any persons or entities acting at the direction of Borrower or with Borrower’s knowledge or consent gave materially false, misleading, or inaccurate information or statements to Lender (or failed to provide Lender with material information) in connection with the Loan. Material representations include, but are not limited to, representations concerning Borrower’s occupancy of the Property as Borrower’s second home.”

Scenario

Imagine you have closed on your old property, communicated with your lender the intent to hold the property as an investment and now with your replacement property closing scheduled tomorrow you receive a phone call from your lender alerting you that the loan must be revisited or additional fees and a higher interest rate must be assessed. Why after all the effort complying with lender regulations, countless emails and follow ups is a change required at such late notice?

Higher Loan Fees and Interest Rate

This happens even after a 1031 exchange was explained, including providing a copy of the Delayed Exchange Agreement and relinquished settlement statement clearly indicating a 1031 exchange to the loan processor. If the loan does not need to be revisited, the lender may say the loan can go forward but with a higher interest rate. The issue appears to be the loan is processed as a second home and not an investment property even after the taxpayer has explicitly indicated it is not. The lender must perceive a risk quantified by a higher interest rate.

Outcome Options

The outcome could be for the closing to be rescheduled. But what if the Seller and Realtors are already frazzled after a lengthy negotiation, pushing the close date is not an option? Why at the eleventh hour would the lender red flag the loan? Why wasn’t the loan clearly marked as a 1031 exchange and the appropriate interest rate quoted, verified and in writing from the start?

Constructive Receipt

Let’s say the taxpayer elects not to continue their 1031 exchange after closing on the old property and wants their exchange funds returned. In another words, the taxpayer elects to forfeit the tax deferral effectively canceling the 1031 exchange to close on the property they worked so hard to find, negotiate for a low interest rate … only to learn there is another issue. Once entering a 1031 exchange, the exchange proceeds cannot be returned directly to the taxpayer until the 46^th calendar day post relinquished or old property closing. Talk about adding salt to the wound.

What if the taxpayer has elected a reverse exchange, title of the old property has been parked with the Exchange Accommodator Titleholder, reverse exchange documents are in place and the closing has already been pushed, causing the Seller to be anxious and not agree to reschedule? What are the Buyer’s options? I am not making this up.

Allow the loan officer to revisit the loan to change the interest rate and remove the second home rider, reflecting the loan as it was always intended for an investment property. If the Seller is not willing to wait and there is no support from the Realtors, then forfeit the tax deferral and acquire as a second home. Or when the old property is sold, acquire a replacement property to defer the capital gain. But owning two properties may not be the desired outcome.

The scenarios described happen. From the 1031 perspective, the loan documents are between the taxpayer and the lender. The Qualified Intermediary does get involved in the loan process but only in reverse exchanges when the property parked with the Exchange Accommodator Titleholder is on title. Contact your financial advisor and seek their counsel. The loan may have the Second Home Rider and as long as you are making the loan payments, the lender may not care, but then again they may, in which case paying the higher interest rate is a decision for the taxpayer and finacial advisor to make, not the Qualified Intermediary.

Must Haves

• When applying with for a loan, be sure to state that the replacement property is to be held as an investment to qualify for a 1031 exchange.

• Submit a letter to the loan officer clearly stating the intent to secure the loan to acquire a replacement property in a 1031 exchange.

• Follow up with the loan processor or officer before the scheduled closing to confirm a second home rider is not attached to the loan.

• Trust, but verify.

Learn “Ten Reasons Why a 1031 Exchange Makes Sense” by clicking here.

We Can Help 

Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.

Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.