Tax-Free Exchanges of Aircraft Under Section 1031
Boot Netting Rules
Under Section 1031
© 1999 KEITH G. SWIRSKY
A. Minimizing Boot
A party who receives boot (i.e., money or other non-like-kind property) in a like-kind exchange will generally be liable for tax on the amount realized (as defined above) from the exchange to the extent of the boot. Therefore, it is highly desirable to minimize the amount of boot received in a like-kind exchange. According to the IRS, non-deductible expenses paid in connection with a transaction may be used to offset boot received in the exchange. Rev. Rule. 72-46, 1972-2 C.B. 468. Such expenses may include: attorneys' fees in connection with structuring the exchange; attorneys' fees in connection with the transfer of the properties and the closings, accountants' fees, brokers' fees for the property transferred and/or acquired, mortgage fees, appraisal fees, intermediary fees and trustees' fees.
Note that these expenses may be used to offset boot only. A taxpayer may earn interest income on funds deposited in a qualified trust or escrow. Generally, such interest income would be taxable. Could transaction expenses be used to offset this interest income? The answer may depend upon whether the interest income falls under the definition of "boot." The Regulations define boot as money or other property received in a like-kind exchange. It would seem, then, that interest income would be boot subject to offset only if it were received in the exchange.
In addition, the Regulations establish the following rules for offsetting boot received in a like-kind exchange:
1. Debt assumed on the acquisition of replacement property offsets debt relief on the disposition of relinquished property.
2. Debt assumed on the acquisition of replacement property will not offset cash received on the disposition of relinquished property.
3. Cash paid on the acquisition of replacement property offsets debt relief on the disposition of relinquished property.
B. Mortgages and Boot
The above rules deal specifically with a case in which debt is assumed as part of the exchange. For example, if a taxpayer disposes of relinquished property that is subject to a mortgage, the assumption of that mortgage by another party would ordinarily constitute taxable boot to the taxpayer. However, under Rule 1, if the replacement property acquired by the taxpayer is also subject to a mortgage, the taxpayer's assumption of that debt will offset the boot from the relief of the taxpayer's debt.
In some transactions, however, a mortgage on relinquished property may not be subject to assumption, but may require being paid off in cash. If a taxpayer receives cash from the purchase of the relinquished property and uses the cash to pay off the mortgage, a question arises whether the cash received constitutes taxable boot. On this issue, the Tax Court has ruled that cash received in an exchange will not be boot if the taxpayer is contractually required to use the cash to pay off the debt on the relinquished property at the time of the exchange. Barker v. Commissioner, 74 T.C. 555 (1980). The Tax Court reasoned that, where a taxpayer is contractually required to pay off the mortgage with the cash received, the taxpayer never "receives" the cash in a meaningful sense, but serves merely as a conduit for the money. Note, however, that this rule applies only where the use of the cash is restricted to mortgage payment and such mortgage payment is a necessary condition of the overall exchange agreement.
CAVEAT: If property to be exchanged in a like-kind exchange transaction is refinanced prior to the like-kind exchange transaction, at a time when the like-kind exchange is anticipated or being discussed or planned, the Service may re-characterize such refinancing as "cash received on the disposition of relinquished property," and if such cash is not used to acquire the replacement property, this may constitute boot and therefore result in current taxation.