Like-Kind Exchange

[jainen]

ignore the mortgages completely

Some people are just not getting my point. I’ve tried to make it simple, but perhaps my credibility has been damaged by posts on certain other topics. Anyway, I will now demonstrate exactly why you must ignore the mortgages completely.

Before I do, I want to warn you that JJ EA is NOT using Tax Tools as he claims. That fine program does not calculate “realized gain deferred” using new and old mortgages. First it calculates realized gain, with no mention of mortgage. Then it calculates recognized gain, using “decrease in mortgage.” This is a reference to the Section 1031 rules about netting mortgage boot, which is the assumption of a mortgage by the buyer, seller, or exchangor. That didn't happen in the original post. As I said before, mortgage banks don't support loan assignments any more, at least not for residential housing.

An interesting thing about this transaction: The mortgage payoff was 287K, but the purchase price had only been 139K. Obviously there was a cash-out refinance in the last 15 years. Unless the refi was connected to the exchange, it is not considered boot and does not affect the deferral of gain. Pretty good deal, huh? But it really messes up the numbers unless you ignore the mortgages completely.

This property sold for about $626,000 (287463 payoff + 54960 costs + 283884 net proceeds). The adjusted basis plus exchange costs was $121,563, so the realized gain was about $505,000—none of which was recognized because he didn’t take out any boot. Compare that to the figure JJ EA offers, $432,900. The difference is in trying to count the old mortgage as money he “got.” Actually, he had to pay off that debt, anything he “got” happened years ago and doesn’t count here. That’s a perfect example of why you must ignore the mortgages completely.

The new mortgage is just as misleading. JJ EA says he “gave” $585,000, but that was money received. The reason he needed so much is that half of the exchange proceeds went to the old payoff (including the cash-out) and had to be replaced. The actual new value added was only 243K (869 minus 626). Yes, I know I’m rounding horribly and I didn’t mix in the $17,000. But whether you say new price (869K) minus deferred gain (505K), or exchange basis (121K) plus new money (243K), the total new basis is about $364,000.

I’m tellin’ you -- you must ignore the mortgages completely.

[natiro]

1031 exchange

I disagree with jainen (regarding whether or not mortgages should be ignored) although I may be wrong about my interpretation of this Reg. Here it is anyway:

Reg 1.1031(d)-2

For the purposes of section 1031(d), the amount of any liabilities of the taxpayer assumed by the other party to the exchange (or of any liabilities to which the property exchanged by the taxpayer is subject) is to be treated as money received by the taxpayer upon the exchange, whether or not the assumption resulted in a recognition of gain or loss to the taxpayer under the law applicable to the year in which the exchange was made.


It seems to me that when this Reg says "(or of any liabilities to which the property exchanged is subject)". . .isn't that saying that the liabiltiles don't necessarily have to be assumed by the other party? The relief of liabilities is to be treated as money received (boot.)

I'm interested in more discussion on this issue.

[jainen]

ignore the mortgage completely

>>any liabilities to which the property exchanged by the taxpayer is subject<<

That clause (which doesn't appear in the code) is a piece of history. In olden days, before qualified intermediaries, an exchange would often involve multiple parties, so that you would trade to one person and receive a replacement from somebody else, and they would work out their own "leg" between themselves. Mortgages could be traded too, back then, so you had to net your loans regardless of who had what. It was a challenge. Notice that all the examples in Reg. 1.1031(d)-2 are about property transferred subject to the loan. Nowadays we use a single intermediary, and the loans must be paid off before clear title can be transferred.

When I say ignore the mortgage completely, I’m only talking about the realized gain, the recognized gain, and the basis of the new property.

Suppose instead of exchanging he just sold his property for $626K. Since his adjusted basis was $121K, the gain is 505. Of course the client will complain that he didn’t get that much money because he had to pay off his old mortgage, but we would hold fast that how he spends his proceeds doesn’t affect his gain. We ignore the mortgage completely.

Suppose instead of exchanging he was just buying a property for $869K. He put 283 cash down and financed the rest. What is his basis? He’s only out of pocket 283, but he books the full 869. The source of funds does not affect his basis. We ignore the mortgage completely.

An exchange is no different, except that the two transactions are combined. He gives his house to Starker Services and they give him a new one. Only problem is that the new one is worth more, so Starker says, we’ll trade you this one for yours plus $250K. It doesn’t matter where he gets the 250. He pulls 17K from a sock under his pillow and begs and borrows and scrounges the rest. The source of funds does not affect his basis. We ignore the mortgage completely.

Another problem—there’s a lien on his old house. It doesn’t matter what that lien is from, but he has to clear it. So he begs and borrows and scrounges a little more to cover that and pay the transaction costs. How he spends his proceeds doesn’t affect his gain. We ignore the mortgage completely.

[Gene V]

ignore the mortgage

Jainen, now that makes sense, why didn’t you explain it like that before, instead of just saying ignore the mortgage completely, remember there are some thick skulls out there. Thanks again for the explanation.

[JJ EA]

Basis

I don't have time to digest all the info you overnight posters added this morning. I did want to add something to my previous post on basis. The figure that I came up with assumed that all of the 54,960 and the additional 17,000 was for "exchange expenses" not loan expenses or Sch E items. Anything that is going to be deducted on Sch E or amortized as loan costs would be deducted from the 436,100 amount, otherwise they would be deducted twice. With the HUD statements to break those items out I think we would come up with a figure very close to Jainen's. I think the hardest part of getting the numbers right on the exchange is the analysis of everything on the HUD 1 statements.

Have a great tax day!

[jainen]

a certain logic

There's a certain logic to thinking that if you pay a loan with exchange proceeds you have taken boot, especially if the loan wasn't even used to buy the property. To understand why this is not so, you must look to the history of like kind exchanges.

Section 1031 is very old, going back to the rural barter economy of the 1920's. Taxes had to be paid in cash but the trades didn't generate any, so tax was deferred as long as the investment was continued in kind.

In the 1930's we got FNMA and Freddie Mac loans and a new problem--mortgage over basis. With 30-year loans and 18-year depreciation, there came a time when adjusted basis was zero but you still owed money. Tax rates up to 90% meant you couldn't pay the tax from sale proceeds. 1031 was very popular and several variations developed. The most successful was to use a professional intermediary.

They didn't necessarily ignore the mortgages back then. Loans were based on equity so you could transfer property "subject to" the mortgage. You never had to repay the mortgage because the value of the property was adjusted for purposes of the trade and the new owner took on the liability. Nowadays banks base the loan on personal credit and don't allow substitute borrowers. You have to pay off the loan before you sell or exchange, so the FMV is not adjusted. That's why now we ignore the mortgages completely.

Fifty years later as property values soared we discovered a new way to incur mortgage over basis--the cash-out refi. By now the old rule was firmly established and still applied as long as you didn't pull the cash out during the exchange itself.

You can see why 1031 is such a powerful technique. It is possible to take tax-free cash for any reason and not have to account for it when the property is disposed of. Even though the old loan might not have been fully deductible you can pay it off with exchange proceeds and make up for it with a bigger, fully-deductible new acquisition loan. The client has not only used the gain tax-free for personal expenses, but has even converted the personal-use funds to a deductible mortgage, and leveraged the whole investment into a more valuable property at the same time!

For these reasons the client will be quite interested in the mortgages. But in calculating gain and basis, the tax preparer must ignore the mortgages completely.