A few simple rules can help prevent taxpayers from getting the ‘boot.’
Like-kind exchanges allowed under Section 1031 of the tax code are a valuable method of deferring the payment of capital gains taxes on the sale of qualified property. However, if the taxpayer receives cash or cash equivalents from the sale or uses exchange proceeds for non-qualified expenses, it may be considered “boot” and result in reportable capital gains.
When 1031 exchange proceeds are used to buy a hotel, for example, only the building and land will be considered like-kind in the exchange. Personal property, such as the beds, desks and chairs that are included in the sale cannot be paid for with exchange funds, or it will be taxed as boot.
To avoid boot, a taxpayer should purchase personal property and real property in a separate transaction. The taxpayer can also allocate the purchase price between the personal property and the real property and pay for the personal property with other funds and not exchange proceeds.
Any cash or cash equivalents, like promissory notes received in the exchange will be considered boot and taxable. In a like-kind exchange, the property sold by the taxpayer is called the “relinquished property” and the property being purchased is called the “replacement property.”
The net cash received by the taxpayer after the completion of the exchange is boot. This happens when the taxpayer does not spend all of the cash received from the sale of the relinquished property to purchase the replacement property. In addition to cash, any property received by the taxpayer in a tax-deferred exchange not of like-kind to the property that was sold also is considered boot.
All real property is considered like-kind. A taxpayer can sell an office building and use the proceeds to buy an apartment building. But personal property is not like-kind to real property. If a taxpayer sells a building and uses the money to buy another building and personal property, the fair market value of the personal property is considered boot.
Safe exchange expenses
Exchange proceeds can be used to pay certain expenses without resulting in any tax liability for the taxpayer. The allowable costs must be directly related to the purchase or sale of the property in order to be paid for with exchange proceeds.
Expenses that are acceptable non-taxable uses of exchange proceeds include due-diligence inspection fees, realtor commissions, qualified intermediary fees, transfer taxes, deed recording fees and title insurance search costs.
Costs to avoid
Avoid paying any costs not directly related to the purchase or sale of the property. For instance, loan fees such as prepaid interest, points, commitment fees, mortgage broker commissions and third-party costs of the bank's inspectors such as engineers and appraisers may not be paid with exchange funds.
Even the mortgage recording fees, mortgage recording tax and the portion of the title insurance premium that is allocated to the loan title insurance policy should be paid with other funds to avoid boot.
Adjustments and other closing costs are a little trickier and the taxpayer needs to be cognizant of the types of closing costs that can be paid for with exchange funds.
Generally, exchange proceeds can only be used for acquisition costs but not typical ownership expenses. That means that closing adjustments such as prorated rents and taxes, security deposit adjustments and utility adjustments should be not be paid with exchange proceeds.
Any expenses that a lender or title company requires to be paid in advance as a condition of closing should also be paid with other funds and not exchange proceeds. Such costs include real estate taxes, sewer taxes, water charges and items of similar character.
It's important to remember that if you use exchange proceeds to purchase property that is not like-kind, or if you use it to pay non-qualified expenses, you run the risk of having the proceeds treated as taxable boot. However, if you are careful you will be able to maximize your 1031 exchange and not get booted by mistake.
Steven Gellerstein serves as an attorney with law firm Meislik & Meislik based in New Jersey. He can be reached at firstname.lastname@example.org.