Development

Category: 1031 Exchange General

  • Changing Tax Laws Create Unique Opportunities

    The results of the recent election cycle will have a profound effect on the United States income tax system.  With Republican control over both chambers of Congress and the Oval Office, we can expect bold moves in tax reform—bold, but not unexpected.  In anticipation of a reform-friendly environment, the House Republicans, prior to the November elections, released an outline for future tax reform.  Released on June 24, 2016 and titled, “A Better Way, Our Vision for a Confident America,” the document is the foundation for the Republican’s tax reform efforts.  The outline is also referred to as the “House Republican Blueprint” (HRB), and while only 35 pages in length, it seeks to begin a “conversation about how to fix our broken tax code.”
    While few can accurately predict the outcomes of 2017 tax reform, the consensus view is that corporate tax rates will be reduced from current levels. While the timelines and the degree of these reductions are unknown, savvy CFOs are recognizing opportunity in the face of this uncertainty. Many tax advisors are looking at ways to defer current taxation to a post-tax reform future with a lower rate and a more favorable environment. This “tax arbitrage” situation might very well result in permanent deferrals and once-in-a-lifetime opportunities for businesses.
    Two Potential Tax Reform Plans
    Here is a brief look at two of the tax reform plans that have been talked about:
    The House Republican Blueprint – Tax Rate Details
    The HRB looks to change income tax rates in the following ways:

    Individuals – Reducing tax brackets from seven to three, with a top bracket of 33% as opposed to the current 39.6%.  Alternative minimum tax (AMT) would be repealed.
    Sole proprietors and pass-through entities – For active business income, tax rate would be capped at 25%.  Currently, this income passes through the entity and is reported by the owner(s) and taxed at the owner’s rate(s).  In some cases, the owner’s rates can exceed 40%.
    C-corporations – taxed at a single rate of 20% and a complete repeal of the alternative minimum tax.  Currently, these rates can be as high as 39%.

    While the rate cuts are significant, they are but a small sample of the overall HRB. 
    Donald J. Trump’s Plan – Tax Rate Details
    Since tax reform will require cooperation with the president, here is a review of some highlights from President Donald Trump’s tax proposal:

    Individuals – Similar to the HRB with a reduction from seven tax brackets to three and the same reductions in tax rates as the HRB.
    C-corporations – Tax rate would drop from 35% to 15%, and the alternative minimum tax would be eliminated.

    An Opportunity for Owners of Heavy Equipment
    With both proposals, it’s plain to see that lower tax rates are most certainly on the horizon.  For owners of heavy equipment, lower rates offer a chance to conduct a like-kind exchange within a high tax environment to defer income taxation into a lower tax environment. 
    Recognizing gains in a lower tax environment, often referred to as tax arbitrage, takes advantage of an opportunity for sellers of personal property to permanently reduce income tax through changing tax laws.
    Let’s look at an example where the taxpayer sells equipment in a high tax environment, conducts a like-kind exchange, and effectively defers $18,824 of income taxation.
    Then, in a future (lower tax) environment, that same taxpayer sells the replacement equipment without conducting another like-kind exchange.  Instead, the equipment owner chooses to recognize the sale’s income as a taxable event.  For simplicity’s sake, let’s use the same sales and depreciation figures used above.
    The advantage of combining the deferral benefits of like-kind exchanges with an arbitrage strategy is clear.  The equipment owner’s recognition of income in a 20% tax rate environment permanently saves the owner $9,412 in taxation – the difference between the 40% and 20% tax rates.
    Summary
    New tax arbitrage opportunities are good news for equipment owners who take the initiative to carefully engage with their tax advisors and qualified intermediary to ensure their goals are met and that the planning process fits squarely within the parameters of the law. With proper planning, 2017 tax reform could present your business with a rare opportunity.
    For more on 2017 tax reform or if you’d like additional information on tax arbitrage opportunities, contact us today.
    (866) 397-1031
     

  • Changing Tax Laws Create Unique Opportunities

    The results of the recent election cycle will have a profound effect on the United States income tax system.  With Republican control over both chambers of Congress and the Oval Office, we can expect bold moves in tax reform—bold, but not unexpected.  In anticipation of a reform-friendly environment, the House Republicans, prior to the November elections, released an outline for future tax reform.  Released on June 24, 2016 and titled, “A Better Way, Our Vision for a Confident America,” the document is the foundation for the Republican’s tax reform efforts.  The outline is also referred to as the “House Republican Blueprint” (HRB), and while only 35 pages in length, it seeks to begin a “conversation about how to fix our broken tax code.”
    While few can accurately predict the outcomes of 2017 tax reform, the consensus view is that corporate tax rates will be reduced from current levels. While the timelines and the degree of these reductions are unknown, savvy CFOs are recognizing opportunity in the face of this uncertainty. Many tax advisors are looking at ways to defer current taxation to a post-tax reform future with a lower rate and a more favorable environment. This “tax arbitrage” situation might very well result in permanent deferrals and once-in-a-lifetime opportunities for businesses.
    Two Potential Tax Reform Plans
    Here is a brief look at two of the tax reform plans that have been talked about:
    The House Republican Blueprint – Tax Rate Details
    The HRB looks to change income tax rates in the following ways:

    Individuals – Reducing tax brackets from seven to three, with a top bracket of 33% as opposed to the current 39.6%.  Alternative minimum tax (AMT) would be repealed.
    Sole proprietors and pass-through entities – For active business income, tax rate would be capped at 25%.  Currently, this income passes through the entity and is reported by the owner(s) and taxed at the owner’s rate(s).  In some cases, the owner’s rates can exceed 40%.
    C-corporations – taxed at a single rate of 20% and a complete repeal of the alternative minimum tax.  Currently, these rates can be as high as 39%.

    While the rate cuts are significant, they are but a small sample of the overall HRB. 
    Donald J. Trump’s Plan – Tax Rate Details
    Since tax reform will require cooperation with the president, here is a review of some highlights from President Donald Trump’s tax proposal:

    Individuals – Similar to the HRB with a reduction from seven tax brackets to three and the same reductions in tax rates as the HRB.
    C-corporations – Tax rate would drop from 35% to 15%, and the alternative minimum tax would be eliminated.

    An Opportunity for Owners of Heavy Equipment
    With both proposals, it’s plain to see that lower tax rates are most certainly on the horizon.  For owners of heavy equipment, lower rates offer a chance to conduct a like-kind exchange within a high tax environment to defer income taxation into a lower tax environment. 
    Recognizing gains in a lower tax environment, often referred to as tax arbitrage, takes advantage of an opportunity for sellers of personal property to permanently reduce income tax through changing tax laws.
    Let’s look at an example where the taxpayer sells equipment in a high tax environment, conducts a like-kind exchange, and effectively defers $18,824 of income taxation.
    Then, in a future (lower tax) environment, that same taxpayer sells the replacement equipment without conducting another like-kind exchange.  Instead, the equipment owner chooses to recognize the sale’s income as a taxable event.  For simplicity’s sake, let’s use the same sales and depreciation figures used above.
    The advantage of combining the deferral benefits of like-kind exchanges with an arbitrage strategy is clear.  The equipment owner’s recognition of income in a 20% tax rate environment permanently saves the owner $9,412 in taxation – the difference between the 40% and 20% tax rates.
    Summary
    New tax arbitrage opportunities are good news for equipment owners who take the initiative to carefully engage with their tax advisors and qualified intermediary to ensure their goals are met and that the planning process fits squarely within the parameters of the law. With proper planning, 2017 tax reform could present your business with a rare opportunity.
    For more on 2017 tax reform or if you’d like additional information on tax arbitrage opportunities, contact us today.
    (866) 397-1031
     

  • Changing Tax Laws Create Unique Opportunities

    The results of the recent election cycle will have a profound effect on the United States income tax system.  With Republican control over both chambers of Congress and the Oval Office, we can expect bold moves in tax reform—bold, but not unexpected.  In anticipation of a reform-friendly environment, the House Republicans, prior to the November elections, released an outline for future tax reform.  Released on June 24, 2016 and titled, “A Better Way, Our Vision for a Confident America,” the document is the foundation for the Republican’s tax reform efforts.  The outline is also referred to as the “House Republican Blueprint” (HRB), and while only 35 pages in length, it seeks to begin a “conversation about how to fix our broken tax code.”
    While few can accurately predict the outcomes of 2017 tax reform, the consensus view is that corporate tax rates will be reduced from current levels. While the timelines and the degree of these reductions are unknown, savvy CFOs are recognizing opportunity in the face of this uncertainty. Many tax advisors are looking at ways to defer current taxation to a post-tax reform future with a lower rate and a more favorable environment. This “tax arbitrage” situation might very well result in permanent deferrals and once-in-a-lifetime opportunities for businesses.
    Two Potential Tax Reform Plans
    Here is a brief look at two of the tax reform plans that have been talked about:
    The House Republican Blueprint – Tax Rate Details
    The HRB looks to change income tax rates in the following ways:

    Individuals – Reducing tax brackets from seven to three, with a top bracket of 33% as opposed to the current 39.6%.  Alternative minimum tax (AMT) would be repealed.
    Sole proprietors and pass-through entities – For active business income, tax rate would be capped at 25%.  Currently, this income passes through the entity and is reported by the owner(s) and taxed at the owner’s rate(s).  In some cases, the owner’s rates can exceed 40%.
    C-corporations – taxed at a single rate of 20% and a complete repeal of the alternative minimum tax.  Currently, these rates can be as high as 39%.

    While the rate cuts are significant, they are but a small sample of the overall HRB. 
    Donald J. Trump’s Plan – Tax Rate Details
    Since tax reform will require cooperation with the president, here is a review of some highlights from President Donald Trump’s tax proposal:

    Individuals – Similar to the HRB with a reduction from seven tax brackets to three and the same reductions in tax rates as the HRB.
    C-corporations – Tax rate would drop from 35% to 15%, and the alternative minimum tax would be eliminated.

    An Opportunity for Owners of Heavy Equipment
    With both proposals, it’s plain to see that lower tax rates are most certainly on the horizon.  For owners of heavy equipment, lower rates offer a chance to conduct a like-kind exchange within a high tax environment to defer income taxation into a lower tax environment. 
    Recognizing gains in a lower tax environment, often referred to as tax arbitrage, takes advantage of an opportunity for sellers of personal property to permanently reduce income tax through changing tax laws.
    Let’s look at an example where the taxpayer sells equipment in a high tax environment, conducts a like-kind exchange, and effectively defers $18,824 of income taxation.
    Then, in a future (lower tax) environment, that same taxpayer sells the replacement equipment without conducting another like-kind exchange.  Instead, the equipment owner chooses to recognize the sale’s income as a taxable event.  For simplicity’s sake, let’s use the same sales and depreciation figures used above.
    The advantage of combining the deferral benefits of like-kind exchanges with an arbitrage strategy is clear.  The equipment owner’s recognition of income in a 20% tax rate environment permanently saves the owner $9,412 in taxation – the difference between the 40% and 20% tax rates.
    Summary
    New tax arbitrage opportunities are good news for equipment owners who take the initiative to carefully engage with their tax advisors and qualified intermediary to ensure their goals are met and that the planning process fits squarely within the parameters of the law. With proper planning, 2017 tax reform could present your business with a rare opportunity.
    For more on 2017 tax reform or if you’d like additional information on tax arbitrage opportunities, contact us today.
    (866) 397-1031
     

  • Avoid Boot from Rent and Security Deposits in a 1031 Exchange

    Taxable Boot Related to Prepaid Rent and Security Deposits
    In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing.  In that context, the net amount paid to the seller for the property at closing is simply reduced.  However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
    This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain.  Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
    Let’s Look at an Example
    Take the case of a taxpayer selling a multi-family apartment building for $500,000.  Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent).  Let’s also assume that the total of security deposits held by the taxpayer is $25,000.  So the taxpayer has a total of $45,000 of cash in his pocket.  Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs. 
    If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000.  However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
    How Is this Problem Corrected?
    In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
    Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
    Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
    Real estate taxes are looked at a bit differently.  Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable.  The payment of real estate taxes generally are billed and paid in arrears.  So the taxpayer has not received income on that sum, rather it is a liability of the property. 
    The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated.  Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount.  “Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
    Are These Same Considerations Relevant to the Replacement Property Closing?
    Similar issues arise when there are credits to the taxpayer at closing.  Credit that the taxpayer receives for these items will be treated as taxable cash boot.  Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot.  In the event a credit is given, the rent is treated as rental income.  The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
    Summary
    It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues.  In a closing involving a

  • Avoid Boot from Rent and Security Deposits in a 1031 Exchange

    Taxable Boot Related to Prepaid Rent and Security Deposits
    In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing.  In that context, the net amount paid to the seller for the property at closing is simply reduced.  However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
    This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain.  Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
    Let’s Look at an Example
    Take the case of a taxpayer selling a multi-family apartment building for $500,000.  Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent).  Let’s also assume that the total of security deposits held by the taxpayer is $25,000.  So the taxpayer has a total of $45,000 of cash in his pocket.  Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs. 
    If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000.  However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
    How Is this Problem Corrected?
    In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
    Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
    Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
    Real estate taxes are looked at a bit differently.  Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable.  The payment of real estate taxes generally are billed and paid in arrears.  So the taxpayer has not received income on that sum, rather it is a liability of the property. 
    The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated.  Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount.  “Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
    Are These Same Considerations Relevant to the Replacement Property Closing?
    Similar issues arise when there are credits to the taxpayer at closing.  Credit that the taxpayer receives for these items will be treated as taxable cash boot.  Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot.  In the event a credit is given, the rent is treated as rental income.  The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
    Summary
    It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues.  In a closing involving a

  • Avoid Boot from Rent and Security Deposits in a 1031 Exchange

    Taxable Boot Related to Prepaid Rent and Security Deposits
    In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing.  In that context, the net amount paid to the seller for the property at closing is simply reduced.  However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
    This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain.  Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
    Let’s Look at an Example
    Take the case of a taxpayer selling a multi-family apartment building for $500,000.  Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent).  Let’s also assume that the total of security deposits held by the taxpayer is $25,000.  So the taxpayer has a total of $45,000 of cash in his pocket.  Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs. 
    If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000.  However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
    How Is this Problem Corrected?
    In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
    Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
    Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
    Real estate taxes are looked at a bit differently.  Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable.  The payment of real estate taxes generally are billed and paid in arrears.  So the taxpayer has not received income on that sum, rather it is a liability of the property. 
    The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated.  Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount.  “Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
    Are These Same Considerations Relevant to the Replacement Property Closing?
    Similar issues arise when there are credits to the taxpayer at closing.  Credit that the taxpayer receives for these items will be treated as taxable cash boot.  Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot.  In the event a credit is given, the rent is treated as rental income.  The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
    Summary
    It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues.  In a closing involving a

  • Avoid Boot from Rent and Security Deposits in a 1031 Exchange

    Taxable Boot Related to Prepaid Rent and Security Deposits
    In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing.  In that context, the net amount paid to the seller for the property at closing is simply reduced.  However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
    This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain.  Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
    Let’s Look at an Example
    Take the case of a taxpayer selling a multi-family apartment building for $500,000.  Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent).  Let’s also assume that the total of security deposits held by the taxpayer is $25,000.  So the taxpayer has a total of $45,000 of cash in his pocket.  Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs. 
    If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000.  However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
    How Is this Problem Corrected?
    In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
    Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
    Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
    Real estate taxes are looked at a bit differently.  Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable.  The payment of real estate taxes generally are billed and paid in arrears.  So the taxpayer has not received income on that sum, rather it is a liability of the property. 
    The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated.  Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount.  “Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
    Are These Same Considerations Relevant to the Replacement Property Closing?
    Similar issues arise when there are credits to the taxpayer at closing.  Credit that the taxpayer receives for these items will be treated as taxable cash boot.  Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot.  In the event a credit is given, the rent is treated as rental income.  The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
    Summary
    It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues.  In a closing involving a

  • Avoid Boot from Rent and Security Deposits in a 1031 Exchange

    Taxable Boot Related to Prepaid Rent and Security Deposits
    In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing.  In that context, the net amount paid to the seller for the property at closing is simply reduced.  However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
    This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain.  Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
    Let’s Look at an Example
    Take the case of a taxpayer selling a multi-family apartment building for $500,000.  Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent).  Let’s also assume that the total of security deposits held by the taxpayer is $25,000.  So the taxpayer has a total of $45,000 of cash in his pocket.  Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs. 
    If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000.  However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
    How Is this Problem Corrected?
    In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
    Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
    Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
    Real estate taxes are looked at a bit differently.  Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable.  The payment of real estate taxes generally are billed and paid in arrears.  So the taxpayer has not received income on that sum, rather it is a liability of the property. 
    The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated.  Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount.  “Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
    Are These Same Considerations Relevant to the Replacement Property Closing?
    Similar issues arise when there are credits to the taxpayer at closing.  Credit that the taxpayer receives for these items will be treated as taxable cash boot.  Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot.  In the event a credit is given, the rent is treated as rental income.  The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
    Summary
    It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues.  In a closing involving a

  • Avoid Boot from Rent and Security Deposits in a 1031 Exchange

    Taxable Boot Related to Prepaid Rent and Security Deposits
    In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing.  In that context, the net amount paid to the seller for the property at closing is simply reduced.  However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
    This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain.  Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
    Let’s Look at an Example
    Take the case of a taxpayer selling a multi-family apartment building for $500,000.  Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent).  Let’s also assume that the total of security deposits held by the taxpayer is $25,000.  So the taxpayer has a total of $45,000 of cash in his pocket.  Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs. 
    If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000.  However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
    How Is this Problem Corrected?
    In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
    Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
    Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
    Real estate taxes are looked at a bit differently.  Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable.  The payment of real estate taxes generally are billed and paid in arrears.  So the taxpayer has not received income on that sum, rather it is a liability of the property. 
    The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated.  Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount.  “Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
    Are These Same Considerations Relevant to the Replacement Property Closing?
    Similar issues arise when there are credits to the taxpayer at closing.  Credit that the taxpayer receives for these items will be treated as taxable cash boot.  Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot.  In the event a credit is given, the rent is treated as rental income.  The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
    Summary
    It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues.  In a closing involving a

  • Avoid Boot from Rent and Security Deposits in a 1031 Exchange

    Taxable Boot Related to Prepaid Rent and Security Deposits
    In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing.  In that context, the net amount paid to the seller for the property at closing is simply reduced.  However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
    This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain.  Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
    Let’s Look at an Example
    Take the case of a taxpayer selling a multi-family apartment building for $500,000.  Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent).  Let’s also assume that the total of security deposits held by the taxpayer is $25,000.  So the taxpayer has a total of $45,000 of cash in his pocket.  Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs. 
    If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000.  However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
    How Is this Problem Corrected?
    In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
    Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
    Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
    Real estate taxes are looked at a bit differently.  Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable.  The payment of real estate taxes generally are billed and paid in arrears.  So the taxpayer has not received income on that sum, rather it is a liability of the property. 
    The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated.  Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount.  “Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
    Are These Same Considerations Relevant to the Replacement Property Closing?
    Similar issues arise when there are credits to the taxpayer at closing.  Credit that the taxpayer receives for these items will be treated as taxable cash boot.  Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot.  In the event a credit is given, the rent is treated as rental income.  The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
    Summary
    It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues.  In a closing involving a