Like-Kind Exchanges and QIs

The premise is simple: a taxpayer exchanges a property for one that is similar and defers the tax consequences.

Example 1: At arm’s length, A exchanges property X, with a $10 fair market value (FMV) and a $5 adjusted basis, with B for property Y, with a $10 FMV and a $9 adjusted basis. Without Sec. 1031, A has a $5 taxable gain and a $10 basis in the new property. However, under Sec. 1031(a), A has a $5 deferred gain and a $5 carryover basis in Y. (Note: the relative values of the two properties is irrelevant; even if X’s value is appraised at $20, the result is the same.)

Congress’s intent (back in 1924) with the like-kind exchange rules was to refrain from imposing tax when no cash would result from a transaction that seemed to have no real consequence. Thus, Sec. 1031(b) provides that the receipt of other property in a like-kind transaction will trigger gain recognition up to the FMV of such property received (“boot”).

Example 2: The facts are the same as in Example 1, except that X’s FMV is $20 and B pays A $10 for the difference in property values. The $5 deferred gain and $5 basis still result; additionally, A recognizes a $10 gain (total realized gain is $15), equal to the cash received.

Congress did not originally anticipate that an exchange might not be simultaneous. Further, “like-kind” in the real estate context has been defined broadly; today, any two pieces of real estate held for investment or business use (but not inventory) are like-kind, which has generated a cottage industry of qualified intermediaries (QIs). The QI-involved transaction is the most common form of modern Sec. 1031 real estate exchanges. Essentially a three- or four-party transaction (including the QI), such an exchange is quite different from the two-party type contemplated by the 1924 law, which raises some problems. The following discussion addresses some issues this causes in practice.

Form HUD-1

Real estate transactions are recorded on a settlement sheet (Form HUD-1, Settlement Statement), as required by Federal law. This form is used to report an exchange accurately and reflects the financial settling-up of the parties. The two transacting parties—the ones involved in the transfer of legal title to the real property—are referred to on Form HUD-1 as the “seller” and the “borrower.” The question in the case of a four-party like-kind exchange is: Who should be listed as the party opposite the third party on the HUD form—the taxpayer or the QI?

Although under Regs. Sec. 1.1031(k)-1(g)(8), Example 4, a QI need not have legal title to any of the properties involved, a complication arises as to the funds exchanged for the property. This occurs because a taxpayer is barred from having access to funds in the course of the exchange, before completion. A “settlement” means that the taxpayer has access to funds from the settled transaction. Thus, in practice, the QI appears as the party on the settlement sheet, for both the purchase and sale of the old and new properties.

Access to funds: The funds-access issue is vital. The QI agreement must limit the taxpayer’s right to receive, pledge, borrow or otherwise benefit from proceeds; see Hillyer, TC Memo 1996-214 and Letter Ruling 200027028.

To meet the notice requirements applicable in multiparty like-kind exchanges, Form HUD-1 should indicate that the transactions are being undertaken for purposes of a like-kind exchange on the taxpayer’s behalf.

The ban on access to funds during the transaction applies to the taxpayer, not to the QI; indeed, the QI will use some (if not all) funds received from the sale of the old property to acquire the new one.

A potential problem arises in the case of earnest deposits, which, if received by the taxpayer, could be deemed to be access to funds. If necessary, earnest deposits should be handled through an escrow arrangement (i.e., via a real estate broker), which arguably should withstand IRS scrutiny. Any other receipt of cash by the taxpayer from the buyer of the old property cannot be cured by contributing it back through the QI; see Regs. Sec. 1.1031(k)-1(g)(3)(iv).

Boot: A payoff of a taxpayer’s existing mortgage is equivalent to being relieved of a mortgage; thus, it is boot. Such boot may be offset to the extent that another mortgage was incurred (or assumed) on the new property. The mortgage incurred, to the extent it exceeds its boot counterpart, is considered cash given in the exchange. Giving cash increases basis in the new property, but it is not netted against boot. Exchange expenses offset boot.

Four-Party Exchange Example

The Form HUD-1 of a client who bought and sold properties via a four-party like-kind exchange demonstrates the above rules; see Exhibits 1 and 2. The relevant columns are those belonging to the taxpayer—the seller’s side in Exhibit 1, and the borrower’s side in Exhibit 2; thus, the counterparty’s information has been purposely left blank.

The boot received is the net of the exchange funds, representing the funds the QI held and then disbursed in the sell and buy transactions, respectively, or $687,328 ($834,028 – $146,700), plus the payoff of the $100,000 loan, for a total of $787,328. Added to this are $729 of assessments ($512 + $217) paid for the taxpayer, which is boot (however, the taxpayer’s receipt of typical closing transactional costs (including assessments) are not regarded as having access to funds, under Regs. Sec. 1.1031(k)-1(g)(7)). Total boot is now $788,057. The mortgage on the new property more than offsets the payoff of the old loan; thus, the $100,000 payoff is removed from boot; total boot is now $688,057.

The net amount to be received ($687,328) is the amount the taxpayer should have received from the QI (less a typical QI fee of about $750 per transaction). The ultimate receipt should be confirmed with the taxpayer, for two reasons. First, confirmation will verify the correct amount of boot to report. Second, unsuspecting clients may be entitled to a windfall due to “inadvertent bookkeeping errors” on the QI’s part.

Exchange expenses offset boot, which can become complicated. The exchange expenses listed on the seller’s side of Form HUD-1 reduce the amount received; thus, there is no further action to take on that side in this respect. On the borrower’s side, however, the exchange expenses increase the amount to be paid by the buyer; thus, these expenses ($11,486) may reduce boot (under the “one exchange” rationale). The QI fees, which are not shown on Form HUD-1, should be added to this amount. Thus, assuming these fees are $750, the result is $12,236. (QI fees can be verified by confirming the amount received by the taxpayer from the QI.)

As a result, Form 8824, Like-Kind Exchanges (and section 1043 conflict-of-interest sales) reporting would be: line 15, $675,821 ($688,057 – $12,236); line 16, $450,000 (the new property’s FMV); line 17, $1,125,821 (line 15 + line 16). Note: the remaining $203,514 of the new mortgage ($315,000 – $100,000 offset – $11,486 attributable to exchange expenses) cannot offset the boot.

If it is assumed that the old property is fully depreciated, with $38,653 adjusted basis remaining (for the land), and the accumulated depreciation is $97,347, the remaining $215,000 of the new mortgage is added to this. The $11,486 in settlement fees reduces this result (as such, boot is instead being offset). The $3 paid is also included at settlement. Thus, the total for Form 8824, line 18 is $242,170. The realized gain is $883,651 ($1,125,821 – $242,170).

How much gain should be recognized? The line 15 amount, $675,821, as it is less than the gain realized. Basis in the new property is $242,170.

If the property were rental investment property, $675,821 would be reported on Form 4797, Sales of Business Property (Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2)) and Form 1040, Schedule D, with $97,347 as the unrecaptured Sec. 1250 amount on Schedule D. There would also be a Form 1040, Schedule E deduction of $729 for the assessments.

Importance of Settlement Dates

Form HUD-1 lists the settlement dates of the transactions. These are important, as a like-kind exchange that straddles two tax years may be treated as an installment sale, making all of the amounts in the example (except perhaps the assessment on the 2005 sale transaction) reportable in 2006, not 2005. (Actually, in the example, part of the gain needs to be reported in 2005, under Temp. Regs. Sec. 15A.453-1(b)(3)(i), because the liabilities relieved ($100,000) exceed the property’s adjusted basis ($38,653).)

The remaining $215,000 new mortgage does not offset the boot; the boot, essentially, equals the remaining exchange funds refunded to the taxpayer at the exchange’s completion. Why did the taxpayer not forgo the mortgage financing and use the available QI funds for the difference instead, thereby saving $215,000 in recognized gain (realized gain remains the same)? In this case, the taxpayer was negotiating a purchase of a second property and determined a need for these funds in the second purchase. However, the second deal was never completed. Instead, the taxpayer should have arranged other financing not tied to these transactions and refinanced (if desired) at a later date. The extra interest on such financing, plus the refinancing costs, would have been much less than the tax due currently on $215,000.

From Dan Wise, CPA, Gorfine, Schiller & Gardyn, P.A., Owings Mills, MD