1031 exchange liabilities

[natiro]

Client had a 1031 exchange in 2006. The property sold was real property on which the client spent a year making improvements and then sold.

On the closing statement, the following liabilities were paid from proceeds:

1. Mortgage secured by the property sold
2. Mortgage secured by other rental property for which 100% of the proceeds were used to make improvements to the property sold in the exchange
3. Two credit cards for which 100% of the balances were for expenses used to improve the property sold.

Are either #2 or #3 above considered liabilities given up in the exchange or are they considered cash boot received?

Also, in considering liabilities, do you look at liabilities actually assumed by another party(which rarely, if ever happens) or do you look at liability relief (old debt) vs. new debt? Just curious to hear thoughts about this.

Thanks.

[abby]

cash

I'm going to have to go with cash - just like any other payment that may be made out of escrow, these would be cash paid for the benefit of the seller. In the exchange calculation, anything beyond the liability would be treated as such, even if it is tied to the property, like taxes or interest payments.

I believe the mortgage boot calculation would only apply to the debt relief on the property secured by the property being exchanged. The payoff of that debt is not considered cash on behalf of the seller but an obligation tied to the property.

You do get the basis and the traced interest on the items purchased with the the other loans, naturally, so your gain has been reduced by the purchases financed through these means, but the choice of financing whenever a property is improved can be so varied that tieing these loans into the liabilities given up seems a stretch.

Maybe the bottom line is that the taxpayer could have chosen to not payoff these loans.

It won't automatically create boot, however - as cash in can offset cash out.

On the assumed mortgage issue:
There has been some discussion on the board by a party or two that believes the rules that most of use to calculate mortgage boot only applies to real assumed mortgages, but all the worksheets I've ever used and classes I've ever taken and articles I've ever read say that mortgage boot is calculated on how much debt relief is received on the sold property vs how much debt is obtained on the new one. No mortgage boot if the purchased property has greater debt. I don't believe those parties have a voice here any longer, so someone else will have to pick up that guantlet.

Hope that helps.

[natiro]

Abby - 1031 exchange

Thank you Abby for your answer. I have read the "liabilities assumed" discussion on various tax boards (including this one probably, although it didn't come up in my search) and agree with your interpretation.

I agree with you, too, on your answer to the first part of my question. Thanks for the confirmation.

You always have good answers to the 1031 questions and I was hoping to hear from you.

Thanks again.

[abby]

you're quite welcome

Aren't you in my neck of the woods? If I'm recalling correctly that you are - stay cool!

[natiro]

Abby

Abby. . . .yes, I think we're both in Oregon. I'm in Eugene and it was over 100 yesterday. I'm the only person I know who's actually happy about that!

Thanks again!

[Roland Slugg]

Dear Natiro

The credit card debt is recourse debt and is not being assumed by the other party. Thus, it can not be treated as a liability assumed. The debt on the other property may be recourse debt or nonrecourse debt, but in either case since the other party did not acquire that other property, I don't believe the debt can be considered as assumed by him. This is so even though the tracing rules may make it clear that the second loan's proceeds were used to improve the first property. The Code and Regs are not very helpful on this issue, and the instructions for F-8824 (pertaining to line 15) are very difficult to understand.

Regarding your question about liabilities assumed, this was clarified a few years ago in favor of the exchangor. Since the exchangor is dealing with an qualified intermediary, that QI is treated as the party who, (A) buys the property from the exchangor, assuming the debt thereon, and (B) delivers the replacement property to the exchangor, along with the newly arranged debt on it. Due to direct deeding it may not appear the above is what happens, but since everything flows through the QI, it is, and that's why there really is an exchange of debt. If this weren't the case, non-simultaneous exchanges would be next to impossible to arrange if there were any debt involved.

[wexeter]

Follow-up

Abby is right on the money.

The debt created and secured by another property merely created an "additional cash investment" into the subject property, which must be reinvested into the like-kind replacement property.

Costs to repair or fix-up a property can not be paid out or reimbursed to the investor at the closing with out creating boot.

The pay down of personal credit card debt also creates boot.

The best way to look at it is that 1031 exchange proceeds have been redirected for the payment of something other than like-kind replacement property.

[Corduroy Frog]

Exeter

Exeter, you have a lot to offer those of us on the message board. Especially in the area of property transfers.

Come back and visit us often for these and other tax matters.

Regards, Corduroy Frog

[natiro]

Thank you

Thank you to all for the excellent replies.