Under IRC Section 1031 (b) and related guidance, it is a general principle that proceeds from a sale used in the exchange cannot be used to pay off liabilities that are unrelated to the relinquished property (they do not share a common nexus). Ideally, such liabilities should be secured to the relinquished property, however the law on this aspect (the nexus) is not clearly defined. Let us dive into this further…
In analyzing whether the payoff of financing associated with a relinquished property has implications on the exchange, we must first understand the difference between “mortgage boot” versus “cash boot”:
- Mortgage boot in a 1031 exchange results when an exchanger reduces the overall amount of debt/financing through an exchange. The “boot” is the net gain or benefit that the exchanger receives due to the replacement real estate’s debt being less than the relinquished real estate’s debt.
- Cash boot is any cash or cash benefit that an exchanger receives out of an exchange, which they have not reinvested into replacement real estate. “Cash boot” includes using proceeds to pay for any item, expense, or liability that is not directly related to the sale. Like mortgage boot, any “cash boot” received is taxable. For more about allowable/non-allowable expenses, see our article here.
Qualifying real estate debt relieved upon sale can be “boot netted” in the exchange by balancing it (by placing an equal or greater amount of acquisition debt on the replacement property), or the taxpayer can inject outside cash/money[i] into the replacement property purchase. To the extent the debt is not fully balanced, the exchanger has debt boot. For more on balancing your exchange, see our article here.
When an exchanger sells relinquished property, the buyer will typically require the seller to satisfy any outstanding liability, so that the buyer does not assume the same upon purchase. In such an event, even though the taxpayer is receiving cash from the sale and using that cash to pay off the mortgage on their relinquished property at closing, the taxpayer is not considered to have received cash boot; this is because the taxpayer is contractually obligated to pay off the mortgage on the property and is therefore deemed to not have control over the funds. In this scenario, the taxpayer, or their qualified intermediary (“QI”), acts as a conduit for payment of the mortgage liability. The key distinction here is the lack of control over the funds, as an exchanger is generally deemed to be in actual or constructive receipt of 1031 funds where they have received or have control over them.[ii] To read more about actual and constructive receipt, see our article here.
Private Letter Ruling (“PLR”) 9853028 applied Treasury Regulation § 1.1031(k)-1(j)(3) to a taxpayer scenario. It held that for netting purposes under §1.1031(b)-1(c), any indebtedness relieved by the buyer in a deferred exchange, is treated as liability boot that can be offset. The rules do not require that the buyer of relinquished property assume a liability for the exchanger to be able to replace it in an exchange.[iii] Liabilities can be paid off with cash from the buyer. To the extent such boot is offset with debt used to acquire replacement property it does not result in constructive receipt as stated above and would not be taxable. Note that as discussed above the exchanger can also use outside cash to offset any net gain stemming from debt relief.
It should also be noted that PLR 201648013 provides that a QI’s utilization of exchange proceeds or its direction to use exchange proceeds to pay down a line of credit secured by the relinquished property will be considered mortgage boot received by the taxpayer, and not cash boot under the boot netting principles of §1.1031(b)-1(c). This would still be true even if the line of credit was used for business purposes unrelated to the relinquished property. In such a case, similarly to the above, the purchase agreement, QI agreement, and the line of credit agreement would have required satisfaction of the debt. In addition, the PLR states that the holding in Barker v. Commissioner, 74 T.C. 555 (1980) supports the principle discussed above, that for purposes of netting debt boot, it is not necessary that there be an actual assumption of a liability by the buyer of relinquished property.[iv]
How about unsecured debt that does not share a nexus with the exchanger’s relinquished property? For example, a business loan. Does that fall into the same category as the above? Probably not. Here is why:
Generally, if not secured, the obligation to pay off debt/liabilities should at minimum be traceable to a requirement in the contract of sale for the real estate (the common nexus)[v]. Existing guidance on this issue does not draw a bright line regarding what would suffice as a common nexus.
If an exchanger wishes to replace debt in an exchange, securing the debt to real estate prior to sale is the most conservative approach. If the exchanger intends to exclude funds from the exchange for purposes such as paying off an unsecured or untraceable debt to an individual partner, or an unrelated business loan, the exchange agreement should specify the amount of funds that are excluded from the exchange and were not assigned to the QI. While we assume that a taxing authority would consider the receipt of the cash benefit as boot, the failure to specify the intended funds to be excluded could open the door to argument that the exchanger had control over exchange proceeds in violation of the QI safe harbors. At a minimum, the benefit of using cash to pay off unrelated liabilities is “boot” and exposes the exchanger to potential tax liability under IRC Section 1031 (b).[vi] Legal 1031 always recommends its exchanger consult with their CPA or tax advisor to determine the amount of gain they will ultimately report in their transaction.
Can I pay off unsecured business debts from the exchange escrow during my exchange? No. This liability is one for which Legal 1031 cannot facilitate payment. Here is why:
This payoff cannot be disbursed from QI escrow once the exchange starts because it is not replacement real estate and would take the exchange out of the QI safe harbors.[vii] Note that as explained above, at the relinquished property closing an unsecured debt can be a disbursement on closing statements. Legal 1031 will sign said closing statement as the QI and process the exchange, so long as the exchanger approves and, at their discretion, reviews the accounting aspects with advisors. The worst-case scenario is “cash boot” and a tax consequence due to cash or cash benefits received by the taxpayer. Therefore, if the exchanger intends on paying off business debt upon the sale of relinquished property, they should ensure they do so before depositing proceeds with the QI.
The foregoing information is intended as a resource to facilitate an educated discussion between an exchanger and their tax and/or legal advisors regarding the treatment of mortgages or other liabilities when transacting a 1031 exchange. As stated above, any “boot” received through the transaction (not reinvested/”like-kind”) is considered to be gain. Legal 1031 does not provide tax or legal advice and cannot qualify nor disqualify any aspects of a 1031 exchange. Therefore, it is critical that a taxpayer speak with their tax and/or legal advisors regarding the accounting aspects and tax consequences of their exchange.
Legal 1031 Exchange Services LLC does not provide tax or legal advice, nor can we make any representations or warranties regarding the tax consequences of any transaction. Taxpayers must consult their tax and/or legal advisors for this information. Unless otherwise expressly indicated, any perceived federal tax advice contained in this article/communication, including attachments and enclosures, is not intended, or written to be used, and may not be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed herein. Information in this article and linked herein may not constitute the most up-to-date legal or other information. We recommend that taxpayers and their advisors independently analyze the merits/pitfalls of various tax strategies and research any new tax law developments and opportunities
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[i] “Outside money” or “outside cash” can come from anywhere outside of the transaction/exchange and refers to funds that do not carry a deferred tax liability (the funds have been previously taxed).
[ii] Once an exchanger or their agent has an “unrestricted right” to sale proceeds, they have likely lost the opportunity to structure their transaction as a valid 1031 exchange due to constructive receipt of the proceeds.
[iii] The PLR equates the taxpayer scenario to that of Treas. Reg. § 1.1031(k)-1(j)(3), Example 5; it concludes that the manner of debt relief is irrelevant. “Except for the fact that Buyer paid the mortgage on Property rather than assume it, the present case is indistinguishable from Example 5. In both cases, the taxpayers are relieved of a debt upon the transfer of the relinquished property and subsequently become obligated under a new debt which is to encumber the replacement property. In example 5, B is deemed to have received money or other property only to the extent that the liability assumed by C exceeds the liability assumed by B.”
[iv] See also PLR 201302009, October 10, 2012 (exchange and debt boot netting permitted where secured debt exceeded the current market value of a property transferred to lenders for forgiveness of nonrecourse debts secured to the real estate).
[v] See Barker v. Commissioner, 74 T.C. 555 (1980); see also PLR 201648013, August 15, 2016 (seller was contractually obligated to pay off debt); Chief Counsel Advice 201325011, September 10, 2012 (business line of credit used to pay business expenses qualified for netting purposes due to the nature of security burden and debt pay-down arrangement).
[vi] Barker at 570, citing Coleman v. Commissioner, 180 F.2d 758 (8th Cir. 1950). “A taxpayer is not allowed to offset cash received by boot given in a case where the taxpayer has received two distinct assets — like-kind property (albeit mortgaged) and cash — and the taxpayer has an unfettered right to do with the cash as he pleases. In that type of case, the taxpayer can exit the transaction with non-like-kind property — the cash. It seems appropriate to trigger the recognition of gain in those circumstances.”
[vii] Treas. Reg. §1.1031(g)(6)