By: John Newman
Tax-free exchanges under Internal Revenue Code Section 1031 allow real estate investors to defer much or even all of the gain on the sale of his property and “roll it over” into another property. Anyone who invests in real estate should become familiar with tax-free exchanges.
In a classic tax-free exchange, the taxpayer would come to a closing with another party and they would swap deeds to two properties making whatever monetary adjustments were necessary. Since it is rare for two parties to want to buy each other’s property, most exchanges involve three parties. Often a Qualified Intermediary facilitates the exchange for a fee. A typical tax-free exchange works as follows:
Tony Taxpayer has an apartment complex in Englewood worth $2,000,000. He wants to sell them and reinvest the proceeds in a shopping center in Hackensack owned by Susie Seller. The Hackensack Shopping Center is worth $5,000,000 and she wants to sell for cash. Bob Buyer wants to buy the Englewood Apartments for cash. With the assistance of Isaac Intermediary, each party will end up with what he or she wants.
| Party | Owns/Has | Wants |
|---|---|---|
| Tony Taxpayer | Englewood Apartments worth $2,000,000 | Hackensack Shopping Center worth $5,000,000 |
| Bob Buyer | Cash | Englewood Apartments |
| Susie Seller | Hackensack Shopping Center | Cash |
Typically the exchange is not simultaneous but deferred. In the first leg of the exchange, Tony sells the Englewood Apartments to Bob for cash. However, by using Isaac as intermediary, the sale is actually done by Isaac, who retains the cash. Tony cannot have actual or constructive receipt of the cash proceeds of the sale.
Within 45 days of the date of the closing, Tony must identify the replacement property he wants to buy, which in this case is the Hackensack Shopping Center. He must close on that shopping center within 180 days of the closing of the sale of the Englewood Apartments or the due date of his tax return (including extensions) whichever is earlier. During that period, he enters into a contract to buy the Hackensack Shopping Center from Susie for $5,000,000. Prior to the closing, he assigns the contract to Isaac who closes with Susie, using the cash from the Englewood Apartment closing plus additional cash and mortgage financing obtained by Tony. After the second closing, Tony has the Hackensack Shopping Center, Bob has the Englewood Apartments, Susie has received cash and Isaac has earned a fee.
The taxation of this transaction works as follow: Tony Taxpayer owns the Englewood Apartments, subject to a $1,000,000 first mortgage, with the following tax characteristics:
$2,000,000 fair market value
800,000 adjusted basis
$1,200,000 realized gain
If Tony were to sell the Englewood Apartments, he would incur a tax liability of approximately $260,000 on that realized gain.
However, by acquiring the Hackensack Shopping Center in an exchange, Tony reinvests all of the $1,000,000 of cash proceeds from the Englewood Apartments as follows:
$1,000,000 proceeds from Englewood Apartments
500,000 additional cash from Tony
3,500,000 mortgage
$5,000,000 purchase price
Under this exchange, there is no recognized gain or tax due because there is no “boot.”
“Boot” is any consideration received other than real property. There are two types of boot: “cash boot” and “mortgage boot.” Cash boot is cash or anything else of value received. Here Tony has not received any net cash – he has used all $1,000,000 of the proceeds from Englewood to buy Hackensack. Mortgage boot is the excess of the liabilities assumed at the sale over the mortgages assumed on the purchase. Tony has not received any mortgage boot because the $1,000,000 mortgage paid off on Englewood is less than the new $3,500,000 Hackensack mortgage.
The “price” for not paying the tax on the sale of Englewood is the reduction of the basis of Hackensack by the amount of the gain deferred:
$5,000,000 cost of Hackensack
– 1,200,000 gain not recognized on Englewood
$3,800,000 new basis in Hackensack
By using the tax-free exchange, Tony has avoided paying $260,000 in taxes at the time of sale and has been able to reinvest that money at the small cost of having a reduced basis in Hackensack. Tax-free exchanges are highly advantageous and should be considered whenever proceeds of a sale are being quickly reinvested in a new property.
This publication is intended for general information purposes only and does not constitute legal advice. The reader should consult legal counsel to determine how the law may apply to specific situations.