Like Kind Exchanges, also known as tax deferred exchanges, are defined by Internal Revenue Code (IRC) section 1031. A 1031 Tax Deferred Exchange offers taxpayers one of the last great opportunities to build wealth and save taxes. By completing a 1031 Exchange, the Taxpayer (“Exchanger”) can dispose of investment or business-use assets, acquire replacement property and defer the tax that would ordinarily be due upon the sale.
Since 1921, section 1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets. The taxes which otherwise would have been due from the sale are thus deferred.
A 1031 Exchange allows investors to defer Federal capital gains tax, state ordinary income tax, net investment income tax, and depreciation recapture on the sale of Investment property if certain criteria are met including:
A 1031 Exchange allows a taxpayer to defer 100% of their capital gain tax liability. To do this, the exchanger must buy new Replacement Property equal to or greater than in value to the property sold and reinvest all the proceeds from the sale of their old property.
But what happens if a taxpayer desires to purchase property lower in value or takes a portion of the cash from the closing of the sale and only invests a portion of their proceeds towards a 1031 Exchange? The good news is that these transactions still qualify for tax deferral under Section 1031 of the Tax Code. They simply become “partial” 1031 Exchanges where the taxpayer has a partially tax deferred transaction rather than deferring all their taxes.
The portion of the exchange proceeds not reinvested is called “boot” and is subject to capital gains and depreciation recapture taxes. Usually, boot is in the form of cash, an installment note, debt relief or personal property and is valued to be the “fair market value” of the non-like-kind property received. It is important to understand that the receipt of boot does not disqualify the exchange; it merely introduces a taxable gain into the transaction.
Whether your 1031 goal is full or partial deferral, work with your tax and legal advisors to strategically make your 1031 work best for your situation.
Here are a few scenarios to illustrate partial and full deferral strategy:
If you fit into these scenarios:
but your goal is to defer 100% of your taxes, consider these potential solutions:
The important point is to not assume that you need to pay taxes if you cannot locate property at the right values or have a need for cash. Everyone’s tax situation is different so always seek the guidance of a tax advisor prior to beginning your transactions.
The term boot refers to non-like-kind property received in an exchange. Usually, boot is in the form of cash, an installment note, debt relief or personal property and is valued to be the “fair market value” of the non-like-kind property received. It is important to understand that the receipt of boot does not disqualify the exchange; it merely introduces a taxable gain into the transaction. The Exchanger has a “partially tax deferred exchange” rather than a “fully tax deferred exchange”. Accordingly, any non-like-kind property received in an exchange will be taxed, up to the amount of realized gain from the sale of the relinquished property.
Some common examples of boot are:
To avoid having boot, the Exchanger should follow three rules:
As a practical matter, satisfying the first two rules; buying equal or greater value property and reinvesting all of the exchange funds, will result in the debt requirement being satisfied.
Refinancing to pull equity out of a property prior to or after completing a tax deferred exchange can result in a taxable transaction under the “step transaction doctrine.” The IRS can argue that a “cash-back” refinancing, immediately before the exchange is completed, is just one step in many steps that results in not reinvesting all of the equity from the Relinquished Property. It follows that the refinance loan proceeds would be taxable as boot. This “step transaction” doctrine allows the IRS to re-characterize seemingly separate transactions into one transaction for tax purposes. The result is an unfortunate outcome for the Exchanger if the IRS believes that there was no independent business purpose for the refinance. In other words, the threshold question is, “was the purpose of the loan nothing more than the Exchanger’s desire to take cash out of the equity of either the Relinquished or Replacement Properties without paying tax?”
In Fred L. Fredericks v. Commissioner, TC Memo 1994-27, 67 TCM 2005 (1994), the Exchanger refinanced the Relinquished Property two weeks after executing a contract to sell the property and less than a month prior to the resulting exchange. Using the step transaction doctrine, the IRS argued that the refinance proceeds should be considered taxable boot. The Exchanger prevailed by showing that he had attempted to refinance the property over a two-year period. In this instance, the Court concluded that the refinance transaction: a) had an independent business purpose; b) was not entered into solely for the purpose of tax avoidance; and c) had its own economic substance which was not interdependent with the sale and exchange of the Relinquished Property.
Exchangers should discuss their plans to refinance with their tax advisors and carefully consider the following issues to help avoid the pitfalls of the “step transaction doctrine”:
