In the United States, upon the sale of property, a taxpayer generally must pay a capital gains tax on the realized gain, which in some cases can be in upwards of 40 percent of the realized gain. The realized gain is determined by the difference between the original purchase price of the property, plus capital improvements less depreciation and the selling price less the selling expenses. With such a high potential capital gains tax, in can often bring in to question whether the sale of the property will end up being profitable or not.
Exchange Blog
Del Rio Ranch 890 Acres – 1031 Eligible
Lake Amistad Ranch located 25 miles north of Del Rio, Texas is an eligible 1031 exchange property. This 890 acre ranch has water access to the number one Bass lake in the United States, Lake Amistad. Owner has access to fish, swim, canoe or other water activities is available along with hunting for white-tail deer, quail, doves and javelinas.
Deferred Taxes
Deferred taxes is the outcome of Section 1031 of the Internal Revenue Code for taxpayers in certain qualifying situations. The rules on deferred taxes are very strict, but if they are met, the benefits can be substantial. Section 1031 allows a property owner to defer the federal and state capital gains tax that would typically be due at the time of the sale of the property until a point in time in the future if the proceeds and debt retired from the sale are equal to or greater in the replacement property.
Capital Gains Tax
As most taxpayers already know, the sale of a capital asset potentially exposes the seller to a capital gains tax obligation. In order to avoid owing capital gains taxes, a basic understanding of capital assets and gains is in order.
Reverse Exchange
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.
Unsecured Liabilities in a 1031 Exchange
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.