COVER STORY, MARCH 2005

EXCHANGE EQUATION
Achieving 100% Tax Deferral Through 1031 Real Estate Exchanges.
Pamela Michaels

Smart investors are increasingly turning to 1031 exchanges to defer the payment of capital gain taxes, preserve their equity and increase their purchasing power. To ensure 100 percent 1031 tax deferral when exchanging investment properties, one must satisfy two basic requirements.

• Invest all of the net equity derived from the sale of the relinquished property in one or more replacement properties.

• Acquire one or more replacement properties with debt that is equal or greater to the debt on the property being relinquished or sold.

For example, if a taxpayer relinquished one investment property for $1 million that had a mortgage of $600,000 and incurred exchange expenses of $60,000, the “exchange equation” would look like the following:

Purchase Price $1,000,000
Debt             -$  600,000
Expenses       -$    60,000
_______________________
Net Equity      $340,000

Thus, the investor must use the entire $340,000 (net equity) to acquire one or more replacement properties and incur debt of at least $600,000 on such properties. One exception to the debt placement requirement is that the investor may acquire property with debt of less than the existing debt, $600,000 in this instance, provided that the investor invests additional cash in the replacement property equal to the shortfall. In such case, the equation might look like this.

Although the investor in the above case reduced its debt by $100,000, the investor invested an additional $100,000 cash in the deal, thus offsetting the reduction in debt and avoiding boot (money or property received after an exchange of property of like kind but unequal value).

Cash Boot and Mortgage Boot

Investors should note that all is not lost if the investor fails to fully meet both of these requirements. As shown below, the investor is taxed only on the cash boot or mortgage boot received.

Cash boot can be demonstrated as follows: 

In the above example, the investor would incur cash boot of $100,000, which would be subject to capital gains taxes and depreciation recapture. The term “cash boot” refers to any proceeds actually or constructively received by the investor. In the above example, since the investor pocketed $100,000 of cash from the sale of the relinquished property, that portion would be taxable to the extent of the investor’s gain.

Suppose, however, that the investor purchases replacement property valued at only $800,000 with debt of $500,000 and equity of $300,000. In this case the debtor would pocket $100,000 in proceeds, which would be taxable as cash boot and, in addition, be relieved of $100,000 of debt.

Trading down in debt is known as “debt relief” or “mortgage boot.” As the debt owed by the investor in connection with the property has been reduced by $100,000, the investor is considered to have received the economic benefit of $100,000 and will incur tax on that $100,000 to the extent of the investor’s gain. Thus, in total, the investor would incur tax on $200,000 — the total cash and mortgage boot.

Improvement Exchange

Another means that some investors use to avoid boot and balance equities is to perform an “Improvement Exchange.” Where the investor desires to acquire replacement property and thereafter improve the replacement property, the investor may avoid boot and use exchange equity or debt to improve the replacement property by following the parameters established by Revenue Procedure 2000-37.

Rev. Proc. 2000-37 basically provides that exchange equity or debt can be applied to the cost of the replacement property and any improvements completed to it within the 180-day exchange period by utilizing a parking arrangement whereby title to the replacement is parked with an affiliate of the Qualified Intermediary, also known as an Exchange Accommodation Titleholder (EAT). The equity/debt invested in such case includes the original purchase price plus the value of the improvements completed within the 180-day exchange period for purposes of matching equity and debt between the relinquished property and the replacement property.

Pamela Michaels is the Northeast division manager for Asset Preservation Inc.

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