FINANCING ISSUES

It is rare that a Section 1031 exchange will involve properties that are debt-free. In fact, it is typical that the taxpayer’s relinquished property will be subject to a mortgage that needs to be paid off in the transaction and that the replacement property will be financed in part with the proceeds of a loan. As a result, a number of financing-related issues may arise in connection with an exchange.

The basics. The Regulations provided that consideration received by the taxpayer in the form of an assumption of his liability or the transfer of his property subject to a liability is to be treated as "other property or money" (usually referred to as "boot"). Reg. § 1.1031(b)-1(c). Thus, if A were to transfer his apartment building subject to a $2 million mortgage, boot in the amount of $2 million would be recognized pursuant to this rule. However, this result is mitigated by the so-called "liability netting" rule whereby, in determining the amount of boot, the taxpayer can offset against the liabilities on the relinquished property any liabilities related to the replacement property. (Similarly, the taxpayer could offset his liabilities relieved of through the transfer of cash to the exchanging party). See Reg. §1.1031(d)-2, ex’s (1) and (2).

While these rules may appear straightforward, the application of them in the context of traditional lending practices, the practical requirements of business transactions and the objectives of the taxpayer raise a number of important issues.

Pay-Off of Loan on Relinquished Property.

In most multi-party exchanges, the exchanging taxpayer will use the proceeds from the disposition of the relinquished property to satisfy the liability attaching to that property and will then enter into a new financing (often with a different lender) to acquire the replacement property. From a strictly technical standpoint, no liabilities are "assumed" or "taken subject to" in the transaction. One loan is paid off and another loan is incurred.

Despite this technical issue, the IRS ruled nearly 20 years ago that, in the context of a simultaneous exchange at least, the acquisition indebtedness is to be netted against the liabilities relieved because such indebtedness is treated either as liabilities assumed or cash paid by the taxpayer. TAM 8003004 (Sept 19, 1979). See also Commissioner v. North Shore Bus Co.,143 F.2d 114 (2d Cir. 1974); Barker v. Commissioner, 74 T.C. 555 (1980).

This still left the question of how the loans should be treated in a deferred exchange where there could be a substantial period between retirement of the relinquished property debt and establishment of the replacement property.

The Regulations for deferred exchanges following the enactment of the so-called Starker provisions partially answered the question. The netting rule was applied where the debts on both the relinquished and replacement property were assumed. See Reg. § 1.1031(k)-1(j)(3), Ex. 5. By failing to address the much more common situation, however, where the relinquished property debt is retired and a new financing is obtained, the Regulations produced an element of uncertainty in the transactions. Despite this, advisors have generally taken the position that, in view of the legislative enactment of the deferred exchange provisions in the Code, simultaneous and deferred exchanges should be treated the same in applying the netting rules.

In a recent private letter ruling, the IRS indicated its agreement with this conclusion. See LETTER 9853028. In that ruling the buyer of the relinquished property did not assume the taxpayer’s debt because it was financing the purchase from the proceeds of bonds, some of which were transferred to pay off the existing debt, and the taxpayer intended to acquire the replacement property with new debt in an amount that would equal or exceed the debt encumbering the relinquished property. The IRS concluded that "except for the fact that Buyer paid the mortgage rather than assume it, the present case is indistinguishable from Example 5 [of the above-cited Regulations]." While private letter rulings obviously do not have precedent value, nevertheless the publication of the ruling does indicate that the IRS’ stated position is in line with those having been taken by advisors. Refinancing Before and After Exchanges.

In many exchanges, the taxpayer may have substantial equity in his property. Accordingly, in addition to accomplishing deferral on the exchange, there may also be the desire to "cash out" on a tax-free basis through a refinancing either before or after the exchange. Consider this example. A owns an apartment building that has a value of $3 million, a basis of $500,000 and existing debt of $100,000. A would like to do an exchange for a new building but would also like to realize cash proceeds of $1.5 million.

Refinancing before the Exchange One alternative for A to consider is to refinance the building before the exchange and receive the $1.5 million in loan proceeds. The property would then be transferred in the exchange subject to the mortgage. The risk with this transaction is that it might be considered as part of an integrated transaction including the exchange so that the loan proceeds would be treated as cash boot from the exchange. See Long v. Commissioner, 77 T.C. 1045 (1981).

Unfortunately, there are no bright lines tests to determine whether a pre-exchange financing will be subject to the step transaction doctrine. In proposed regulations issued in 1990 the IRS proposed that financings "in anticipation of an exchange" would be treated as boot. As a result of criticisms that the proposed rule would create a substantial amount of uncertainty, the proposal was withdrawn. Nevertheless, the IRS is likely to apply this rule (and has done so in subsequent litigation) where the pre-exchange financing occurs shortly before the exchange.

Is it possible to structure any pre-exchange financing that will work? Certainly one that occurs sufficiently in advance of the exchange so that it is an obligation of the taxpayer for a period of time could pass muster. The case of Fredericks v. Commissioner, T.C. Memo 1994-27, suggests another avenue. If the refinancing occurs for reasons independent of the exchange, such as the pending maturity of existing debt, the step transaction doctrine should not apply.

In summary, a pre-exchange financing creates significant risks that the IRS will treat the proceeds as cash boot, particularly in those instances where the refinancing occurs proximate in time to the exchange.

Refinancing After the Exchange Alternatively, the taxpayer could consider a refinancing after the exchange is completed. Although there is virtually no authority on this issue, most advisors are more comfortable with this technique, particularly where there is a meaningful delay between the exchange and the refinancing. A year delay is a good rule of thumb with 6 months being a relatively aggressive posture.

It should be noted that in a report on Section 1031 open issues, the ABA Section on Taxation took the position that the IRS should publish a revenue ruling that any funds received in a post-exchange financing will not be treated as boot. Their rationale was that in a post-exchange finance the taxpayer continues to be responsible for the repayment of the debt (in contrast to the pre-exchange financing where the taxpayer is relieved of the debt in the exchange). Nevertheless, the IRS has not acted on this recommendation, and taxpayers would be advised to tread carefully in planning post-exchange refinancing.