1031 Exchanges - Lending's Role In An Exchange

DON'T GET KICKED BY THE UGLY BOOT

Section 1031's purpose is to permit taxpayers to defer the capital gain on the sale of appreciated investment property as long as its rules are followed. One of the primary rules is that the sale property must be exchanged for property of like kind (held for productive use in a trade or business or for investment). Non like-kind property is called "Boot." There are two kinds of boot, "Cash Boot" and "Mortgage" boot.

Cash is personal property and is therefore called Cash Boot. When the taxpayer receives some of the cash in an exchange it is called a partial exchange and they will pay capital gain tax on the cash received.

However, if they don't replace the debt that they had on the property they sold that reduction in debt is called Mortgage Boot. I call Mortgage Boot the "Ugly Boot" you do not want to get kicked with (pardon the sloppy grammar). It's Ugly because they taxpayer did not receive any cash to assist him/her in paying the capital gain tax that will be due on the debt reduction. See below for a more detailed explanation of balancing the Exchange Equation.

REALIZED GAIN V. RECOGNIZED GAIN

Whenever property is sold, it is important to make the distinction between realized gain and recognized gain. Realized gain is defined as the net sale price minus the adjusted tax basis. Recognized gain is the taxable portion of the realized gain. The common objective in a tax deferred exchange is disposing of a property containing significant realized gain and acquiring a "like-kind" replacement property so there is no recognized gain.

In order to defer all capital gain taxes, an Exchanger must "balance the exchange" by acquiring replacement property that is the same or greater value as the relinquished property, reinvest all net equity and replace any debt on the relinquished property with debt on the replacement property (although a reduction in debt can be offset with additional cash.)

THE EXCHANGE EQUATION

The Exchanger can quickly calculate whether there will be recognized gain based on the following principals:

Taxable "boot" is defined as non like-kind property the Exchanger may receive as part of an exchange. "Cash boot" is the receipt of cash and "mortgage boot" (also referred to as debt relief) is a reduction in the Exchanger's mortgage liabilities on a replacement property. Generally, capital gain is recognized (and therefore taxable) to the extent there is boot.

For a fully deferred exchange, an Exchanger must reinvest all net equity and acquire property with the same or greater debt. Compare the relinquished property with the replacement property in terms of:

1. Value
2. Net Equity (after deducting costs of sale)
3. Debt

The Exchanger is acquiring property of greater value, reinvesting the entire net equity and increasing the mortgage on the replacement property. Analysis: There is no boot and no recognized gain.

The Exchanger keeps $50,000 of the exchange proceeds, reinvesting only $150,000 as a down payment on the replacement property. Analysis: There is $50,000 of "cash boot" which results in recognized (taxable) gain.

The Exchanger acquires property of a lower value and, while reinvesting all equity in the replacement property, acquires less debt in the process. Analysis: The Exchanger has reduced the debt by $100,000 ("mortgage boot") which results in a recognized (taxable) gain of $100,000.

THIS INFORMATION IS PROVIDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY. THIS IS NOT TAX AND LEGAL ADVICE. TAXPAYERS ARE STRONGLY URGED TO CONSULT THEIR INDIVIDUAL TAX/LEGAL ADVISORS FOR GUIDANCE REGARDING THEIR SPECIFIC CIRCUMSTANCES.

Lisa A. Lambert, Esq. 877.646.1031 or LisaL@apiexchange.com

Asset Preservation, Inc. 800.282.1031 or info@apiexchange.com     www.apiexchange.com