Tax Trap Resulting from Debt in an IRC Section 1031 Exchange
August 25, 2020
By Michael Skoczylas
Whereas interest rates are at historic lows but commercial real estate prices are steadily increasing, taxpayers are increasingly interested in pursuing the tax-deferred exchange provisions of IRC Sec. 1031 (“1031 Exchange”) to minimize or eliminate their current tax burden. (For background on 1031 Exchanges, please see The Basics of 1031s.)
While 1031 Exchanges have been used by taxpayers for many years, there are numerous “tax traps” that taxpayers must be aware of in order to not disrupt the beneficial tax treatment they are expecting, the most common of which is the issue of debt boot on relinquished and replacement properties.
1031 Exchanges in General
Today, most 1031 Exchanges are deferred exchanges, which are facilitated by a qualified intermediary (“QI”). A QI may not be an agent of the taxpayer, but rather a QI enters into an exchange agreement with the taxpayer which allows the QI to a) sell the relinquished property to a third party, b) collect the proceeds, and then c) purchase the replacement property with the proceeds. The QI takes title to both the relinquished and replacement properties for tax purposes only and is not in the chain of title in any other way. When accomplished within the applicable guidelines established in the IRC, Income Tax Regulations, and revenue rulings, the taxpayer will be permitted to defer gain (or loss) on the sale of the relinquished property until the replacement property is sold. However, the replacement property may also be exchanged, and until the taxpayer receives cash or other property which is not like-kind, the tax can be deferred.
One of the requirements for a 1031 Exchange to not trigger any currently recognizable gain is that the taxpayer cannot receive any “other property or money.” Treasury regulations under Reg. §1.1031(d)-2 (and others) state that any liabilities that the taxpayer is relieved of are considered as money received by the taxpayer. Such receipt of money, also called “boot,” triggers the recognition of gain for the taxpayer that sells the relinquished property. However, since most real estate assets are encumbered with debt, even at the time of sale, Reg. §1.1031(b)-1(c) allows taxpayers to net liabilities. The taxpayer can avoid debt boot if the taxpayer incurs, assumes, or takes the property subject to a liability on the purchase of the replacement property that equals or exceeds the debt on the relinquished property, or if the taxpayer uses cash from outside the transaction to replace the debt boot.
When a taxpayer identifies the requirement to replace debt with new or assumed debt, or cash which is not from the proceeds of the sale, a taxpayer has the potential to avoid debt boot. As lenders are becoming more conservative amid the current economic environment while rates remain low, it is important for taxpayers contemplating a 1031 Exchange to consider debt that is being paid off or assumed on the relinquished property. Taxpayers need to ensure that the debt can be replaced with new debt incurred or assumed, or additional outside cash.
Consultation with tax advisors before entering into any sales transaction is recommended, especially transactions structured to take advantage of the 1031 Exchange provisions, as there are many traps and important details that must be adhered to in order to ensure tax deferred treatment.