1031 Exchange – Loan requirement and potential lending issues.
With over twenty five years in this business, I frequently get asked in my seminars by loan agents about this subject a lot. Before we tackle the above, it is critical that we understand what is Cash Boot vs Mortgage Boot in a 1031 exchange.
Under IRC 1031 Exchange – A Taxpayer Must Not Receive “Boot” from an exchange in order for a Section 1031 exchange to be completely tax-free. Any boot received is taxable (to the extent of gain realized on the exchange). This is okay when a seller desires some cash and is willing to pay some taxes. Otherwise, boot should be avoided in order for a 1031 Exchange to be tax free.
The term “boot” is not used in the Internal Revenue Code or the Regulations, but is commonly used in discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money or the fair market value of “other property” received by the taxpayer in an exchange. Money includes all cash equivalents plus liabilities of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject to. “Other property” is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or “non-qualified property.” “Other property” also includes such things as a promissory note received from a buyer (Seller Financing).
Boot can result from a variety of factors. It is important for a taxpayer to understand what can result in boot if taxable income is to be avoided. The most common sources of boot include the following:
Cash boot received during the exchange. This will usually be in the form of “net cash received” at the closing of either the relinquished property or the replacement property.
Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt which was on the relinquished property. Debt reduction boot can occur when a taxpayer is “trading down” in the exchange.
Sale proceeds being used to service costs at closing which are not closing expenses. If proceeds of sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to bring cash to the closing of the sale of their relinquished property to pay for the following non-transaction costs:
– Rent pro-rations.
– Rent pro-rations.
– Tenant damage deposits transferred to the buyer.
– Property tax pro-rations? Maybe, see explanation below.
– Any other charges unrelated to the closing.
Property tax pro-rations on the relinquished property settlement statement can be considered as service of debt based on PLR 8328011. Under this rationale exchange cash used to service tax pro-rations should not result in taxable boot. However, taxpayers may want to bring cash to the relinquished property closing anyway in order to resolve this issue.
Excess borrowing to acquire replacement property. Borrowing more money than is necessary to close on replacement property will cause cash being held by an Intermediary to be excessive for the closing. Excess cash held by an Intermediary is distributed to the taxpayer, resulting in cash boot to the taxpayer. Taxpayers must use all cash being held by an Intermediary for replacement property. Additional financing must be no more than what is necessary, in addition to the cash, to close on the property.
Loan acquisition costs with respect to the replacement property which are serviced from exchange funds being brought to the closing. Loan acquisition costs include origination fees and other fees related to acquiring the loan. Taxpayers usually take the position that loan acquisition costs are being serviced from the proceeds of the loan. However, the IRS may take a position that these costs are being serviced from Exchange Funds. This position is usually the position of the financing institution also. There is no guidance in the form of Treasury Regulations on this issue at the present time which is helpful.
Non-like-kind property which is received from the exchange, in addition to like-kind property (real estate). Non-like-kind property could include the following:
– Seller financing, promissory note.
– Any farm equipment acquired with farm land.
– Farming vehicles.
– Farm animals.
Acquisition of any non real estate assets are all possible issue with the IRS. Most taxpayers report their exchanges of farm land by taking the position that water on the farm land is indistinguishable from, and the same thing as real estate. The IRS has been known to have a different view.
Boot Offset Rules – Only the net boot received by a taxpayer is taxed. In determining the amount of net boot received by the taxpayer, certain offsets are allowed and others are not, as follows:
– Cash boot paid offsets cash boot received (but only at the same closing table). Cash boot paid at the replacement property closing table does not offset cash boot received at the relinquished property closing table (Reg. §1.1031(k)-1(j)(3) Example 2). This rule probably also applies to inadvertent boot received at the relinquished property closing table because of pro-rations, etc.
– Debt incurred on the replacement property offsets debt-reduction boot received on the relinquished property.
– Cash boot paid offsets debt – reduction boot received.
– Debt boot paid never offsets cash boot received (net cash boot received is always taxable).
– Exchange expenses (transaction and closing costs) paid (relinquished property and replacement property closings) offset net cash boot received.
Ownership on title – If I sell my relinquished property for $200K and plan to conduct an equal exchange, what happens if my brother too decides to participate as part of my 1031 exchange? Can he do so? Yes he can as long as the new acquisition building is $400K and higher. In this scenario, I will co-owned the building with my brother joint ownership 50-50%, my 50% interest is $200K which will satisfy the IRS requirement of equal value incurring no taxes in this process.
Vesting issue – Another possible problem is the vesting in a 1031 exchange. Frequently lenders likes to approved loan based on taxpayer’s income. What happens if the exchange is in a LLC? If so, the IRS requires the LLC to be the borrower to satisfy the exchange. While the lending requirement differs! It is never easy, so care must be taken to ensure your lending requirement comply with the IRS exchange regulations first and foremost. Talk to the exchange company to seek guidance to ensure the loan is a correct fit for the intended exchange.
Type of loan – If you have been in the business long enough, some investors will try to “trick” you to help them secure a lower interest rate loan by applying for an owner occupy loan. This is definitely a red flag! Under reporting to the lender if discovered (after closing) will automatically trigger a callable loan payment by the lender. Most loan agreements include the call provision which lenders exercise when they become uncomfortable with the borrower’s documentation or under reporting. If so, the entire exchange will be voided resulting in possible litigation between investor vs loan agent. Not including a taxable event to the investor from a voided exchange!
Rules of Thumb:
– Always trade “across” or up. Never trade down (the “even or up rule”). Trading down always results in boot received either cash, debt reduction or both. The boot received can be mitigated by exchange expenses paid.
– Bring cash to the closing of the relinquished property to cover charges, which are not transaction costs (see above).
– Do not receive property which is not like-kind.
– Do not over-finance replacement property. Financing should be limited to the amount of money necessary to close on the replacement property in addition to exchange funds which will be brought to the replacement property closing.
As you can see, structuring a 1031 exchange loan can be complex and challenging. More so when investor flip, flop from one week to another including adding new partner/s to invest. Simply call us to discuss and we will be happy to help, we are just one phone call away!
Wai-Yew Lam, President
TREC Certified Instructor