Category: Nontaxable Exchanges; Real Estate
Subject: Section 1031 Exchanges
Title: Property Received in Exchange--Requirements for Purchase Price and Debt Restrictions
IRC Sections: 1031
Filename: 1262.html
Date Produced: 08/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
Taxpayer, TP, owns rental real estate with the following characteristics.

Fair market value $145,000
Mortgage 45,000
Cost 103,000
Depreciation 35,985

TP has arranged an exchange intended to qualify under Section 1031.

Issue
With respect to the property to be received in the exchange, what are the limitations on the purchase price and mortgage in order to avoid any gain to TP from the exchange?

Answer
Assuming the transaction qualifies as a tax free exchange under Section 1031 in every other respect, the exchange property must cost at least $145,000 and the debt encumbering the exchange property must not be less than $45,000.

Discussion
Section 1031 simply says no gain or loss is recognized on the exchange of like kind properties. Section 1031 does not utilize any kind of reinvestment-of-proceeds type concept similar to the principal residence rollover provisions of Section 1034.

In order to avoid gain under Section 1031, the transaction must qualify in general and the taxpayer must not receive any nonqualified property, called boot, in the exchange. Any gain realized on the exchange is recognized to the extent of boot received.

Boot is cash or non-like-kind property. If the buyer in the transaction (the person with whom TP will exchange properties) assumes any of TP's debt (or takes TP's property subject to such debt), that assumption is treated as boot. However, TP is allowed to net any boot received in the form of debt relief against any mortgages TP assumes from the buyer. In other words, as long as TP assumes a mortgage at least as great as the one he was relieved of in the exchange, TP has no boot from debt assumption.

This is the rationale behind the conclusion set forth above that the mortgage on the property TP receives in the exchange cannot be less than $45,000.

There is no tax rule that says the value of the property TP receives in the exchange must be no less than the value of the property TP gives up. This is simply a combination of economics and common sense. Since the mortgage on the property TP receives must be at least $45,000, the value of the property must be no less than $145,000. Otherwise, TP has traded a property with $100,000 of equity for a property with equity of something less than $100,000. This has nothing to do with taxation.

In addition, there is a way to accommodate receiving a property with a mortgage lower than $45,000. TP could simply transfer cash or other non-like-kind property to the buyer sufficient to counteract any boot from the trade-down in mortgages. In other words, boot is avoided if the difference between the mortgage relieved and the mortgage assumed is "made up" with cash or non-like-kind property..

Suppose TP locates a property worth $145,000 with a $25,000 mortgage. This property would be a candidate for a totally tax free exchange (as to TP) under Section 1031 if TP transfers the property described above plus cash of $20,000.

Set forth below are several examples drawn from BNA, Tax Management Portfolio 567-1st, that serve to illustrate the concept of boot netting.

Example 1:
A taxpayer, in a transaction qualifying under Section 1031, surrenders property (with a fair market value of $200 and subject to a liability of $100) in exchange for property (with a fair market value of $150 and subject to a liability of $50). Since the transaction resulted in a reduction of $50 in the amount of liabilities to which the taxpayer's property was subject, he is deemed to have received boot to that extent. If the transaction were reversed, the taxpayer would have received no boot in the exchange since he experienced a net increase in indebtedness.

Example 2:
A taxpayer, in a transaction qualifying under Section 1031, surrenders property (with a fair market value of $300 and subject to a liability of $200) plus cash of $50 and securities of $50 in exchange for property (with a fair market value of $250 and subject to a liability of $50). The taxpayer has received boot in the amount of $50: indebtedness relieved ($200), less indebtedness acquired ($50), and cash and securities given ($100).

Example 3:
A taxpayer, in a transaction qualifying under Section 1031, surrenders property (with a fair market value of $350 and subject to a liability of $150) in exchange for property (with a fair market value of $300 and subject to a liability of $200) plus cash in the amount of $100. The taxpayer has received boot in the amount of $100. Although the taxpayer may net boot given against boot received in the form of indebtedness, he may not net boot given against other forms of boot received.