Liabilities

This chapter takes the netting rule established at 33.3 and works out what it means for the property most commonly exchanged, which is a leveraged building that has been depreciated for years.

34.1 Debt relief as boot

The rule is stated twice in the authorities and reaches the same place both times. For purposes of the basis provision, the amount of any liabilities of the taxpayer assumed by the other party to the exchange, or of any liabilities to which the property exchanged by the taxpayer is subject, is treated as money received by the taxpayer upon the exchange, whether or not the assumption resulted in a recognition of gain or loss.¹ The statute adds that such an assumption, determined under section 357(d), is considered money received.²

Note the two formulations. A liability may be assumed by the other party, or the property may simply be transferred subject to it. Either produces the same result, so a taxpayer gains nothing by structuring a transfer as subject to rather than as an assumption.

The assumption determination has a direction practitioners tend to run only one way. A recourse liability is treated as assumed if, on all the facts and circumstances, the transferee has agreed to and is expected to satisfy it, whether or not the transferor has been relieved.³ Formal release is therefore not required for the taxpayer to be treated as relieved. The converse also follows from the text: a formal release does not by itself establish assumption where the transferee has not agreed to and is not expected to satisfy the liability.

The modern deferred exchange reaches the same arithmetic by a different route. In practice the buyer of the relinquished property rarely assumes the mortgage. The property is sold, the mortgage is paid at closing out of the purchase price, and the net proceeds go to the intermediary. The taxpayer's amount realized is the gross contract price, and the payoff is a use of those proceeds rather than a reduction of them.

The consequence is the one every exchange advisor states as a rule of thumb, and it is worth seeing that the rule of thumb is simply this computation. To defer completely, the taxpayer must acquire replacement property of equal or greater value and must reinvest all of the net proceeds. A shortfall in value is boot. Proceeds left over are boot. Whether the shortfall arose because the taxpayer bought a cheaper building or because the taxpayer paid off a mortgage and did not replace the borrowing makes no difference to the arithmetic.

Why this surprises people. A taxpayer who sells a building for $2,000,000 subject to a $1,200,000 mortgage receives $800,000 into the exchange. If the taxpayer then buys a $900,000 building for cash, the taxpayer has replacement property worth $900,000 against $2,000,000 relinquished, and $1,100,000 of boot. The taxpayer received $800,000 and will owe tax measured against $1,100,000. Nothing about that outcome is intuitive to a client who believes the exchange rules are about reinvesting proceeds.

The tax is due for the year of the exchange, and the client will have spent the cash. The computation belongs in a memorandum written before the relinquished property closes, not in a return.

34.2 Offsetting relief against new debt and cash contributed

The netting rule of 33.3 supplies two cures for debt relief and denies one that clients propose constantly.

Debt relief may be offset by debt assumed. A taxpayer relieved of $1,200,000 who takes on $1,200,000 or more on the replacement property has no mortgage boot. Excess debt beyond that produces no further benefit; it is borrowing, not deferral, and it does not offset cash received.

Debt relief may be offset by cash contributed. Consideration given in the form of cash is offset against consideration received in the form of an assumption of liabilities or a transfer of property subject to a liability.⁴ A taxpayer who cannot obtain replacement financing may bring outside cash to the closing instead, dollar for dollar.

Cash received may not be offset by debt assumed. Consideration received in the form of cash or other property is not offset by consideration given in the form of an assumption of liabilities.⁵ The proposal a client will make, which is to borrow heavily on the replacement property in order to take cash out of the exchange, does not work. The cash is boot in full, and the additional borrowing does nothing.

The Service's computation follows the same order. Boot equals cash received, plus the fair market value of non-like-kind property received, plus the excess of liabilities assumed by the other party over the total of liabilities the taxpayer assumed, cash the taxpayer paid, and the fair market value of non-like-kind property the taxpayer gave up.⁶ The subtraction happens inside the liability component and reaches no further.

Three planning consequences follow.

The value test and the proceeds test are separate, and a taxpayer must satisfy both. Buying equal or up in value without reinvesting all the proceeds leaves cash boot. Reinvesting all the proceeds into a cheaper building leaves mortgage boot.

Replacement financing is a tax term as well as a credit term. Where a lender will not extend the amount the taxpayer needs, the shortfall must be covered with outside cash or accepted as boot, and that conversation belongs in the financing timeline rather than at the closing.

Partial deferral is a legitimate outcome and should be quantified rather than avoided. A taxpayer who will recognize $200,000 of gain on a transaction that defers $1,500,000 has done well, and knowing the number in advance is what allows the client to reserve for it.

34.3 Non-recourse debt and property encumbered beyond basis

Two Supreme Court decisions govern the treatment of nonrecourse debt, and together they produce the hardest case in exchange practice.

The first established that a taxpayer's basis in property acquired subject to a nonrecourse mortgage includes the amount of the mortgage, and that the amount realized on disposition includes the mortgage to which the property remains subject.⁷

The second answered the question the first had left open in a footnote. Where the unpaid amount of a nonrecourse obligation exceeds the fair market value of the property, the taxpayer must still include the outstanding amount of the obligation in the amount realized, and the fair market value of the property is irrelevant to that computation.⁸

The consequence for exchanges. A property whose debt exceeds its adjusted basis carries a built-in minimum gain equal to that excess, and no amount of structuring makes it disappear. The taxpayer's amount realized on any disposition includes the full debt, so gain of at least debt minus basis is realized whatever the property is worth.

The condition is common rather than exotic, and it arises without anyone doing anything aggressive. Depreciation reduces basis every year. A refinancing at some point in the past increased debt. After fifteen or twenty years the two lines cross, and a building with substantial equity in the owner's mind has negative equity in the tax computation.

What this means at the closing table. A taxpayer relieved of $3,000,000 of debt on a property with a $1,100,000 adjusted basis has at least $1,900,000 of gain realized before any consideration of value. To defer it, the taxpayer must take on at least $3,000,000 of debt on the replacement property, or contribute the difference in cash, or accept the boot.

Where none of those is available, the recognized gain can exceed the cash the taxpayer receives by a large multiple. This is the circumstance in which a client discovers that selling is unaffordable and that exchanging is only partially available, and it should be surfaced at the first meeting.

The computation to run first. Before anything else in a leveraged exchange, subtract adjusted basis from outstanding debt. That figure is the minimum amount of value and debt the taxpayer must replace, and it frequently changes what the client wants to do.

One refinement applies where a nonrecourse liability encumbers more than the transferred property. The amount treated as assumed by the transferee is reduced by the lesser of the amount that an owner of the other encumbered assets has agreed with the transferee to and is expected to satisfy, or the fair market value of those other assets.⁹ Blanket liens across a portfolio therefore require attention to who is expected to pay what, and the answer is a matter of the loan documents rather than of tax law.

34.4 Refinancing before and after the exchange

Every client who understands 34.2 asks the same question next. If cash received is boot and debt assumed is not an offset, can the cash be extracted as loan proceeds instead.

The mechanics of the idea are straightforward. The taxpayer refinances the relinquished property before the exchange, takes the loan proceeds, and then acquires replacement property carrying debt equal to the increased mortgage. Under the netting rule the debt relief is fully offset by the debt assumed, no boot appears in the computation, and the taxpayer holds the cash. Borrowing is not a realization event, so on its face nothing has been recognized.

There is no safe harbor and no bright line. The regulations do not address the sequence, and the analysis proceeds under the step transaction and substance over form doctrines examined at 42.1.¹⁰ What follows is a description of the exposure rather than a rule, and it should be presented to clients that way.

The question a court or an examiner asks is whether the refinancing and the exchange are properly treated as separate transactions or as steps in one. Several factors bear on it, and none is dispositive.

Timing. A refinancing closed months or years before the property is marketed is in a different position from one closed a week before settlement. The interval is the single most visible fact.

Independent purpose. A refinancing undertaken to fund an unrelated acquisition, to take advantage of a rate environment, or to satisfy a partner buyout has a business reason that exists whether or not the exchange occurs. A refinancing whose only function is to extract cash from a property about to be exchanged does not.

Use of proceeds. Where the loan proceeds went is evidence of why the loan was taken. Proceeds distributed to the owner on the eve of a closing and proceeds invested in an unrelated project look different.

The documents. Loan papers that recite a pending sale, condition funding on the exchange, or contemplate repayment from the exchange closing supply the government's argument in the taxpayer's own words.

Repayment from the exchange. A loan taken shortly before the exchange and repaid out of the closing on the relinquished property is the weakest version of the structure, because the borrowing and the disposition are economically a single event.

Refinancing after the exchange stands on better ground. Once the taxpayer owns the replacement property, borrowing against it is borrowing against the taxpayer's own asset and produces no realization. The exposure narrows to the case where the post-exchange financing was negotiated as part of the exchange and closes with it, which invites the same inquiry from the other direction. Where a client wants leverage on the replacement property, the safer sequence is to close the exchange, hold the property, and finance it afterward as a separate decision with its own documentation.

The advice. The comparison to put to the client is between a certain cost and an uncertain one. Taking the boot is expensive and final. A refinancing position that is later disallowed produces the same tax with interest, in a later year, after a fact intensive examination in which the client's own emails are the evidence. Where the amount is small relative to the exchange, taking the boot is often the better purchase.

Where the client proceeds, three things should be done. Separate the transactions in time as far as the circumstances allow. Record the independent purpose contemporaneously, in a memorandum written when the decision is made rather than when it is questioned. And keep the exchange out of the loan file.