Category: Nontaxable Exchanges; Real Estate Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Facts Issues 1. invalidation of the §1031 exchange; 2. deemed boot from the §1031 exchange; 3. triggering of gain; or 4. impact on Taxpayer's ability to deduct the interest in the new mortgage on Property B. Answers Discussion There is a significant tax controversy regarding debt placed on exchange property immediately before the exchange. It seems to me existence of this controversy could possibly be the thing driving your client's question. In the case of Garcia v. Commr., 80 T.C. 491 (1983), acq., 1984-1 C.B. 1., the IRS challenged the validity of debt placed on exchange property immediately before the exchange transaction. The taxpayer in this case mortgaged exchange property immediately prior to the exchange in order to equalize values and/or eliminate boot. The IRS claimed the mortgage placed on the property in anticipation of the transaction should be ignored thereby creating significant boot in the transaction. The IRS lost this case and ultimately went on to indicate that it would follow the decision. Notwithstanding its acquiescence, however, a later private letter ruling, PLR 8434015, and proposed regulations issued in 1991 took a contrary view. This position was dropped from the final regulations issued in 1991. Accordingly, as to items 1 and 2, above, I cannot locate any indication the facts as set forth above would give rise to an invalidation of the §1031 exchange or deemed boot in the transaction. With respect to item 3, it is well established that placing a mortgage on property is not a taxable event even if the mortgage exceeds the basis of the mortgaged property. Attached is a bit of commentary from a well-respected real estate taxation treatise regarding mortgages in excess of tax basis. The author discusses the situations in which mortgages in excess of tax basis can give rise to taxable gain, e.g., §351 and §721 transactions. Accordingly, I can find no reason to think that mortgaging the Property B after the §1031 exchange in an amount in excess of Taxpayer's basis will give rise to any gain. With respect to item 4, I cannot locate anything to indicate that a mortgage in excess of basis jeopardizes Taxpayer's interest deductions. In fact, mortgages in excess of basis are quite common in the real estate area particularly in times of rapidly rising property values. Refinancing substantially appreciated property is, as you well know, and age-old, tried-and-true method for extracting cash from appreciated property on tax-free basis. Again, it seems to me that a similar tax controversy may be the source of your client's concern. In the Estate of Franklin v. Commissioner, 76-2 USTC ¶9773, 544 F2d 1045, 1048 (9th Cir. 1976), aff'g 64 T.C. 752 (1975), the taxpayer owned property subject to a nonrecourse mortgage which mortgage far exceeded the value of the property. The court held that nonrecourse debt considerably in excess of the fair market value of the underlying property should be ignored for interest expense and basis purposes. In the present case, the debt does not exceed fair market value. Absent some reason to believe the debt is not bona fide, there seems to be nothing in the facts to indicate that an interest deduction should not be available assuming the basic requirements for deductibility are met. |
