Figuring Boot and Taxable Gain - Topic 3
Receiving cash or other boot in a real estate exchange does not defeat the nontaxable provisions of §1031 for the like-kind property involved. If, in addition to the Replacement Property, you receive money or some other kind of boot, you may have taxable gain. But the good news is you are only taxed on gain that comes from the money and other boot received.
Money and unlike property in an exchange is called boot. To figure your taxable gain, determine the fair market value of the boot you receive. Then figure how much your gain would have been if you had sold the property as a regular taxable sale instead. Your taxable gain is the smaller of these two amounts.
If the other party assumes any of your liabilities as part of the exchange, you will be treated as if you received boot in the amount of the liability.
If you receive boot in an exchange, the fair market value of the boot is recognized as taxable gain. However, this gain cannot exceed the amount of gain you would have recognized if the property had been sold in a taxable transaction.
Parallel Point 3-1
You exchange real estate with an adjusted basis of $30,000 for other real estate with a fair market value of $100,000. In addition, you receive $35,000 boot.
Total consideration received $ 135,000
Less-Adjusted basis $ 30,000
Total realized gain is $ 105,000
Total boot received $ 35,000
Your gain is the smaller of the two $ 35,000
Value of real estate received $100,000 plus $35,000 cash.
Reg 1.1031(b)-1 explains rules dealing with receipt of money or other property.
The character of taxable gain is determined by the property sold—not the character of the consideration received. It's determined by the real estate involved in the exchange—not by boot. Think of it this way: In a cash sale, all “boot” received is cash but that does not make all the taxable gain ordinary income. If the relinquished real estate traded is capital gain real estate, any gain recognized from boot received by you will be capital gain. However, if the property is subject to depreciation recapture, the ordinary income from recapture will be recognized before the capital gain.
The depreciation recapture provisions of §1250 (real property) and §1245 (personal property) apply to exchanges as well as sales. These provisions require certain depreciation to be recaptured as ordinary income (instead of long-term capital gain) when the property is sold or exchanged and a gain is recognized.
If you exchange property subject to recapture, and no gain is recognized, the “recapture potential” of the Relinquished Property carries over to the Replacement Property.
If you exchange property subject to recapture, and gain is recognized because of boot taken, the ordinary income portion of the recognized gain is limited to the depreciation that would be recaptured as ordinary income if the property had been sold.
Parallel Point 3-2
You exchange real estate with an adjusted basis of $50,000 for other real estate with a fair market value of $125,000. In addition, you receive $25,000 boot. At the time of sale, your excess depreciation subject to recapture as ordinary income under §1250 was $20,000.
Gain taxable on exchange is $ 25,000
Deduct amount taxable as ordinary income 20,000
Balance – taxable as capital gain $ 5,000
If you exchange property subject to depreciation recapture, and gain recognized because boot taken is less than depreciation that would be recaptured as ordinary income if the property had been sold, all the recognized gain will be taxed as ordinary income. The balance “recapture potential” carries over to the property acquired in the exchange.
Parallel Point 3-3
You exchange rental property subject to recapture of depreciation under §1250. As part of the exchange, you receive boot totaling $30,000. The boot is taxable and you recognize gain in that amount. If you had sold the property, your ordinary income from recapture of additional depreciation would have been $65,000.
The entire $30,000 is taxed as ordinary income and the “recapture potential” of $35,000 carries over to the Replacement Property.
Tax Trap - It's possible, in a §1031 exchange, to recognize gain even if not one cent of boot is received! There’s a little-known rule that can cause you to trigger the entire recapture as ordinary income even if you do not recognize gain figured under the regular exchange rules. Recapture income will be recognized if the fair market value of the depreciable property you receive in the exchange is less than the income subject to recapture. The amount of gain recognized is limited to the difference between the depreciation subject to recapture and the value of the depreciable property.
Parallel Point 3-4
You exchange a large apartment complex for undeveloped investment land. You receive no boot. If you had sold the apartment complex, $122,000 of additional depreciation would have been taxed as ordinary income under §1250. Since the fair market value of §1250 depreciable property received by you (none) is less than the income subject to recapture ($122,000), the entire $122,000 is recognized as ordinary income at the time of exchange.
If there was a rental building on the land with a value of $75,000, only $47,000 of recapture income would be taxed (the difference between the value of the depreciable property ($75,000) and the total subject to recapture ($122,000).
Money and unlike property received in the exchange is boot and is taxable. The amount of boot received is:
the amount of money received plus
the fair market value of unlike property received.
Parallel Point 3-5
You exchange real estate for other real estate plus you receive $10,000 cash and securities with a fair market value of $25,000. Total boot received by you is $35,000.
Other examples of unlike property received in real estate exchanges are gold, silver, foreign currency, airplanes, motor homes, precious stones and real estate to be used as your personal residence.
In a real estate exchange, the assumption of a liability by the other party (or transfer of your property subject to a liability) is treated as boot received by you. It's called mortgage relief. In figuring your net mortgage relief, you may offset against it your assumption of a liability (or transfer of property subject to a liability).
The assumption of a liability or the transfer of a property subject to a liability is treated as boot.
If the other party assumes your liability—or your property transferred subject to the liability—you have received boot. You will be treated as if you received cash in the amount of the liability. The party assuming the liability, or acquiring the property subject to the liability, gives boot.
Parallel Point 3-6
You exchange real estate with an adjusted basis of $30,000 for other real estate with a fair market value of $100,000. In addition, you receive
$35,000 cash and the other party assumes your mortgage of $25,000.Step 1 – Total Gain Realized
Fair market value of like-kind property received $ 100,000
plus cash received 35,000
plus mortgage assumed by other party 25,000
Total Consideration Received $ 165,000
minus Adjusted Basis of property given up 30,000
Total Gain Realized is $130,000
Step 2 – Total Boot Received by You
Mortgage assumed by the other party $ 25,000
plus cash received 35,000
Total Boot Received is $ 60,000
Step 3 – Taxable Gain
Smaller of Total Gain or Boot Received $ 60,000
Reg 1.1031(d)-2 explains rules dealing with treatment of assumed liabilities.
Exchange transactions become more complicated when both properties are mortgaged. If each of you assumes the liability of the other, the liabilities of one are offset against the liabilities of the other. Only the excess is treated as net boot given or received. In other words, the mortgages are netted. You deduct the mortgage you assume from the mortgage on the property given up.
If you do not assume the mortgage on mortgaged property received in an exchange, you are taking the property subject to the mortgage. You are treated as if you assumed the mortgage.
If the mortgage you assume is less than the mortgage on the property given up, the net liability—called mortgage relief is counted as boot received by you.
If the mortgage you assume is more than the mortgage on the property given up, the excess is counted as boot paid by you.
If you transfer unencumbered real estate in exchange for mortgaged real estate, you have paid boot equal to the amount of the mortgage. The payment of mortgage boot does not result in recognition of gain or loss to the person paying it.
Tax Case[xi]: In computing “boot” on three-cornered realty exchange, transferor's receipt of cash to satisfy mortgage on property she transferred was offset by larger mortgage on property she received in exchange. Fact that cash was paid into escrow and mortgage was paid off before transfer was completed didn't bar “netting” of liability discharged against liability assumed. In effect, transferor was merely conduit for funds.
Mortgages on property given up by you are counted as boot received. However, you are permitted to offset mortgages assumed by you against this boot. This is called “netting the liabilities.” If the mortgage balance assumed by you on the Replacement Property is less than the mortgage balance on the Relinquished Property, your net boot from mortgage relief is the difference.
Parallel Point 3-7
You exchange a property with a mortgage balance of $25,000. You assume a mortgage of $12,000 on the Replacement Property you receive in the exchange. Your mortgage relief is $13,000—the difference between the mortgage you assume ($12,000) and the mortgage on the property you transferred ($25,000). This amount—your net mortgage relief—counts as boot received by you.
Mortgage you gave up was $25,000
less mortgage you assumed was $12,000
Your net mortgage relief is $13,000
Important: Liabilities are always netted before other boot considerations are accounted for.
Figuring your net mortgage relief becomes more complicated when the mortgage you assume in the exchange is more than the mortgage on the property given up. The excess is treated as boot paid but is subject to this special offset rule:
Mortgage boot paid offsets mortgage boot received but does not offset cash or unlike property boot received.
Parallel Point 3-8
You exchange land with a mortgage of $10,000 for land with a mortgage of $15,000. In addition, you receive cash boot of $6,000 to balance the equities. After offsetting the mortgages, you figure you have paid $5,000 mortgage boot. However, you are not allowed to offset this mortgage boot paid from the cash boot received. Your taxable boot received is $6,000.
Mortgage given up by you was $10,000
Mortgage assumed by you was $5,000
Net mortgage relief (not less than zero) None
Add - cash boot received $6,000
Total boot received was $ 6,000
Negative mortgage relief counts as boot paid and adds to the basis of Replacement Property. Knowing how this treatment could affect your exchange is essential in your tax planning. Here is another example:
Parallel Point 3-9
You enter into a §1031 exchange. The terms of your exchange include:
· You assume a mortgage of $34,000 on the property you acquire in the exchange.
· The mortgage on the property given up was $20,000.
· You receive cash boot in the amount of $35,000.
Taxable boot received is $35,000—here's how you figure it:
Mortgage on property transferred $ 20,000
Deduct mortgage on property assumed by you 34,000
Difference - may not be less than zero zero
Other boot received by you $ 35,000
Taxable boot received $ 35,000
The mortgage you assumed was $34,000—$14,000 more than your mortgage given up. Following the rules of offset, you were only permitted to reduce your taxable boot received by the amount of your mortgage given up—$20,000. (The difference may not be less than zero. What happens to the $14,000?
The $14,000 is called negative mortgage relief and counts as boot paid. You are not permitted to offset negative mortgage relief against other boot received. Later you will learn how boot paid adds to the basis of property received in an exchange.
Tax Idea - Experienced real estate exchangers are quick to recognize transactions where negative boot relief can result in more gain being recognized from net boot received. The amount in Parallel Point 4-9 is small but add a zero or two zeros to the amount and we are talking about some real money. For example, it the negative mortgage relief was $140,000 or $1,400,000, a good exchanger would seriously consider some financing moves outside the exchange to reduce the negative boot relief to zero if possible. Even though equities would not change, the amount of taxable boot could be substantially reduced. This can be accomplished but only with very careful and knowledgeable planning. You don’t want any financing moves treated by the IRS as part of the exchange transaction.
A very sticky problem faced by many exchangers is anticipatory mortgaging. What happens if you refinance the Relinquished Property prior to the exchange to get cash and raise the mortgage to be assumed or paid off by the buyer?
This could be a great advantage in the exchange:
Borrowing money on your property is not a taxable event.
The higher mortgage increases the amount of mortgage boot received that qualifies for offsetting against mortgage boot paid.
Here is an example: Jones wants to exchange Sunshine Apartments for Brentwood Apartments owned by Allen. The terms of his exchange include:
· Jones assumes a mortgage of $274,000 on the property he acquires in the exchange.
· Jones has a mortgage on Sunshine of $100,000 that will be assumed by Allen.
- Based on the market values of the properties, Jones receives cash boot in the amount $200,000 to balance the equities.
When the exchange is closed, Jones receives taxable boot in the amount of $200,000 making him very unhappy. Here’s how his taxable boot is figured following the offset rules of 1031:
- Mortgage on Sunshine Property relinquished was $100,000 (mortgage boot received)
- Deduct mortgage on Brentwood assumed by Jones - $274,000 (mortgage boot paid)
- This results in a negative offset - $174,000
However, under the rules, mortgage offset cannot be less than zero. Jones gets no boot offset from the difference of $174,000 to offset his cash boot received of $200,000. The result is Jones gets hammered for a $200,000 taxable gain.
Experienced real estate exchangers are quick to recognize transactions where negative boot relief can result in more gain being recognized from net boot received. In our example, Jones should consider borrowing on his Relinquished Property (Sunshine) prior to and outside the exchange transaction. If he refinanced and took out $175,000 cash (non-taxable), his boot would be figured like this:
· Jones assumes a mortgage of $274,000 on the property he acquires in the exchange.
·
Jones has a mortgage on
Sunshine of $275,000
that will be assumed by
Allen.
· To balance the equities, Jones receives cash boot in the amount $25,000.
When the exchange is closed, Jones receives taxable boot in the amount of only $26,000 making him very happy. Here’s how the taxable boot for this exchange is figured following the offset rules of 1031:
Difference – Mortgage relief boot received by Jones is $1,000
- Add Cash boot received of $25,000
- Total boot received by Jones is $26,000
By refinancing outside the exchange, Jones reduces his gain $200,000 to only $26,000.
Tip: Selling expenses paid by Jones are treated as cash boot paid and may be offset against the $26,000 net boot received. In this example, Jones would probably end up with no taxable gain from boot.
In these kinds of cases, exchangers should seriously consider some financing moves outside the exchange to reduce the negative boot relief to zero if possible. Even though equities would not change, the amount of taxable boot could be substantially reduced. This can be accomplished but only with very careful and knowledgeable planning. You don’t want any financing moves treated by the IRS as part of the exchange transaction.
If the refinancing can be demonstrated to be unrelated to the exchange of the Relinquished Property, the proceeds of the refinancing will not be characterized as boot.[xii]
Some time ago, the IRS issued a Proposed Regulation making such mortgage proceeds taxable but it was not adopted. The IRS commented, “Commentators demonstrated the proposed rule could create substantial uncertainty in the tax results of exchange transactions involving liabilities on both Relinquished Properties and Replacement Properties.” The final Regulations did not include this proposed amendment. Ref: Reg 1.1031(b).
Replacement Property may be refinanced after the exchange is closed and the proceeds used by the owner for any purpose. This is a non-taxable event. However, to qualify, the refinancing must not be connected to the exchange transaction such as a contingency for the exchange to close. The exchange agreement and closing statements should be silent regarding the refinancing.
The Tax Court has ruled the payment of the mortgage on the taxpayer’s Relinquished Property is not treated as cash received in figuring the netting of the boot if the payment is contemporaneous with the exchange. The parties involved must require payment of the mortgage and the taxpayer cannot receive or have any right to receive the payment.[xiii]
Many real estate agents and investors when working out the numbers for their real estate exchange often overlook selling expenses as an offset against boot received. Factoring in this offset is critical when the exchange is originated and in the planning stages. Selling expenses paid in connection with a §1031 exchange are treated as cash boot paid and offsets any boot received. Selling expenses include brokerage commissions and other closing costs such as title policy fees, escrow fees, and recording fees.
Parallel Point 3-10
You own property with an adjusted basis of $30,000 and exchange it for like-kind property with a fair market value of $100,000. In addition, you receive $35,000 cash. You pay a $9,000 commission to your real estate broker. Your taxable gain is limited to the net boot received by you—$26,000.
If you receive no cash or property boot in the exchange, but you have net mortgage relief, you may offset sales expenses paid against your net mortgage relief. If the offset creates a “loss”, the Code bars any deduction.
Parallel Point 3-11
You complete an exchange in which you receive $5,000 cash. You pay selling expenses of $9,000. The $4,000 difference or "loss" is not deductible.
If you receive cash or unlike property in addition to the like-kind property received and realize a gain on the exchange, subtract the expenses from the cash or fair market value of the unlike property. Then use the net amount to figure recognized gain.
Caution: Selling expenses cannot be deducted twice against cash boot paid. For example, if you get a down payment of $125,000 on the sale of your Relinquished Property, and you pay $30,000 selling expenses out of the closing escrow, the net proceeds of $95,000 is paid into your QI Trust Account. Since the $30,000 selling expenses have already been deducted from your cash boot received of $125,000, your net boot received is $95,000. You cannot deduct or offset the sales expenses of $30,000 again against your netted proceeds of $95,000.
In the final accounting, selling expenses are recorded on the closing or escrow statements and other supporting documents. Be careful not to include items that must be treated elsewhere on the tax return. For example, rental income adjustments, security deposits, prepaid rents, insurance, realty taxes, points, and interest are not selling expenses and must be treated in the appropriate tax form. Personal items such as payment of liens, personal judgments, and back income taxes are all personal and not selling expenses.
Sometimes you may find it necessary to pay boot in a form other than cash. For example, you may give up precious stones to complete the exchange agreement. In these cases, caution is the byword—you are selling the boot.
âThis is so important, it needs repeating: Any boot you give (payment in part consideration of the Replacement Property) is treated as a straight sale of the boot. The tax-free provisions of §1031 do not apply to boot you transfer in the exchange. If you give money, no gain or loss to you is recognized on the money you give. However, if you give boot in property other than money, a gain or loss will be recognized. The transaction is treated as a sale of the unlike property and the regular gain and loss tax rules apply. The gain or loss is the difference between your adjusted basis in the property and your amount realized. The fair market value is considered to be your amount realized.
For example, as part of an exchange you give unlike property with a cost of $1,000. The fair market value of the property at the time of the exchange is $1,500. You will recognize a $500 gain.
If the personal property was business property (§1245), the gain would be treated as ordinary income to the extent of depreciation taken, and might be taxed as ordinary income.
If the sale of the personal property had resulted in a loss, the loss would be deductible as an ordinary loss since the nonrecognition of gain or loss provision of §1031 does not apply to unlike property.
If you exchange real estate held for business use or investment, you can qualify under §1031 for a nontaxable like-kind exchange. The property you receive in a like-kind exchange is treated as if it were a continuation of the property you gave up.
In a like-kind exchange, you do not recognize gain from the property you receive. But you will recognize gain if you also receive money or other property. Money and other property received is called boot. The fair market value of boot received is recognized gain. However, there's a happy exception if you receive, as part of an exchange, an installment obligation.
Even though the fair market value of the installment note received is boot and recognized as gain under the like-kind exchange rules, the gain may be reported using the installment method of tax accounting. For full coverage see Chapter Eight—Exchanges Involving Installment Sale Notes.
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