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
Category: 1031 Exchange General
-
Avoid Boot from Rent and Security Deposits in a 1031 Exchange
-
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 -
Keep Your BIG (Built-In Gains) from Getting Small
Converting a C Corporation to an S Corporation
Thinking about changing your corporate structure from a C corporation to a subchapter S corporation? S corporations, partnerships, and certain LLCs are considered pass-through entities, which means they “pass through” various types of taxable income: interest, dividends, deductions, and credits to the shareholders, partners, or members responsible for paying tax. This avoids the double taxation associated with C corporations that pay entity-level taxes and then distribute dividends that become subject to individual taxes.
What is Built-in Gains Tax?
With all of the tax advantages provided to S corporations, many companies are making the move. However, there are some pitfalls. One of these is the tax recognition of built-in gains (BIG). Generally, BIG tax is triggered when existing assets are sold during the holding period, a period after the conversion to S corporation status. The holding period is currently 10 years, starting from the date of the conversion. During this period, the existing assets are encumbered by the corporate tax rate of 35%.
For ESOP companies contemplating the conversion from C Corporation to S Corporation, one of the factors to consider is that stock-option purchases generated by employee participation in an ESOP are also subject to the IRC Section 1374 – Built-In Gains (BIG) Tax.
Holding Periods for Built-in Gains Tax
When it comes to tax law, Congress has a habit of letting certain provisions expire, only to extend/amend them in later tax years. Built-in gains are no exception:For 2009 and 2010, Congress shortened the holding period to seven years.
In 2011 through 2013, the holding period was further shortened to five years.
For 2014 and 2015, the holding period is 10 years.The shorter holding periods of prior years proved beneficial for a great number of companies that were concerned about the traditionally long (10 year) holding period, helping many avoid recognizing gains at a punishing 35%.
Disposing of Assets during the Built in Gains Holding Period with a 1031 Exchange
In the ordinary course of business, companies may need to dispose of existing assets, whether those assets are underutilized, aging fleets, idle or obsolete equipment, or rental assets routinely sold and replaced. Holding on to such assets takes up yard space and triggers unnecessary insurance costs and maintenance fees. Exchanging them through a Section 1031 like-kind exchange (LKE) will protect those built in gains from income recognition (taxation), free up working capital, and significantly increase cash flow to continue growing and expanding operations.
Beyond the Holding Period: The Like-Kind Exchange Program
Implementing a 1031 exchange will not only keep the BIG tax at bay, it can reduce or eliminate other holding costs and secure tax benefits beyond the holding period. It is a little bit like having your cake and eating it too. Asset owners that maintain an LKE program throughout the holding period can permanently avoid the pain of BIG tax and implement a business process that protects them from triggering taxation after the holding period ends.
Absent an ongoing like-kind exchange program, future sales will likely be subject to income taxation (flowing out to S Corp owners). Leveraging a 1031 like-kind exchange program immediately after the conversion provides tremendous cash flow opportunities, as does keeping the program in place thereafter.
Summary
Asset owners, with recent C to S corporation conversions should evaluate their tax positions with their advisors, and consider the potential negative impact of their built-in gains. With the help of a qualified intermediary, owners can project the returns that like-kind exchanges can generate by allowing access to a low cost of capital, deferring gain recognition, and ensuring that their BIG will never get small.Contact us for a free consultation.
-
Keep Your BIG (Built-In Gains) from Getting Small
Converting a C Corporation to an S Corporation
Thinking about changing your corporate structure from a C corporation to a subchapter S corporation? S corporations, partnerships, and certain LLCs are considered pass-through entities, which means they “pass through” various types of taxable income: interest, dividends, deductions, and credits to the shareholders, partners, or members responsible for paying tax. This avoids the double taxation associated with C corporations that pay entity-level taxes and then distribute dividends that become subject to individual taxes.
What is Built-in Gains Tax?
With all of the tax advantages provided to S corporations, many companies are making the move. However, there are some pitfalls. One of these is the tax recognition of built-in gains (BIG). Generally, BIG tax is triggered when existing assets are sold during the holding period, a period after the conversion to S corporation status. The holding period is currently 10 years, starting from the date of the conversion. During this period, the existing assets are encumbered by the corporate tax rate of 35%.
For ESOP companies contemplating the conversion from C Corporation to S Corporation, one of the factors to consider is that stock-option purchases generated by employee participation in an ESOP are also subject to the IRC Section 1374 – Built-In Gains (BIG) Tax.
Holding Periods for Built-in Gains Tax
When it comes to tax law, Congress has a habit of letting certain provisions expire, only to extend/amend them in later tax years. Built-in gains are no exception:For 2009 and 2010, Congress shortened the holding period to seven years.
In 2011 through 2013, the holding period was further shortened to five years.
For 2014 and 2015, the holding period is 10 years.The shorter holding periods of prior years proved beneficial for a great number of companies that were concerned about the traditionally long (10 year) holding period, helping many avoid recognizing gains at a punishing 35%.
Disposing of Assets during the Built in Gains Holding Period with a 1031 Exchange
In the ordinary course of business, companies may need to dispose of existing assets, whether those assets are underutilized, aging fleets, idle or obsolete equipment, or rental assets routinely sold and replaced. Holding on to such assets takes up yard space and triggers unnecessary insurance costs and maintenance fees. Exchanging them through a Section 1031 like-kind exchange (LKE) will protect those built in gains from income recognition (taxation), free up working capital, and significantly increase cash flow to continue growing and expanding operations.
Beyond the Holding Period: The Like-Kind Exchange Program
Implementing a 1031 exchange will not only keep the BIG tax at bay, it can reduce or eliminate other holding costs and secure tax benefits beyond the holding period. It is a little bit like having your cake and eating it too. Asset owners that maintain an LKE program throughout the holding period can permanently avoid the pain of BIG tax and implement a business process that protects them from triggering taxation after the holding period ends.
Absent an ongoing like-kind exchange program, future sales will likely be subject to income taxation (flowing out to S Corp owners). Leveraging a 1031 like-kind exchange program immediately after the conversion provides tremendous cash flow opportunities, as does keeping the program in place thereafter.
Summary
Asset owners, with recent C to S corporation conversions should evaluate their tax positions with their advisors, and consider the potential negative impact of their built-in gains. With the help of a qualified intermediary, owners can project the returns that like-kind exchanges can generate by allowing access to a low cost of capital, deferring gain recognition, and ensuring that their BIG will never get small.Contact us for a free consultation.
-
Keep Your BIG (Built-In Gains) from Getting Small
Converting a C Corporation to an S Corporation
Thinking about changing your corporate structure from a C corporation to a subchapter S corporation? S corporations, partnerships, and certain LLCs are considered pass-through entities, which means they “pass through” various types of taxable income: interest, dividends, deductions, and credits to the shareholders, partners, or members responsible for paying tax. This avoids the double taxation associated with C corporations that pay entity-level taxes and then distribute dividends that become subject to individual taxes.
What is Built-in Gains Tax?
With all of the tax advantages provided to S corporations, many companies are making the move. However, there are some pitfalls. One of these is the tax recognition of built-in gains (BIG). Generally, BIG tax is triggered when existing assets are sold during the holding period, a period after the conversion to S corporation status. The holding period is currently 10 years, starting from the date of the conversion. During this period, the existing assets are encumbered by the corporate tax rate of 35%.
For ESOP companies contemplating the conversion from C Corporation to S Corporation, one of the factors to consider is that stock-option purchases generated by employee participation in an ESOP are also subject to the IRC Section 1374 – Built-In Gains (BIG) Tax.
Holding Periods for Built-in Gains Tax
When it comes to tax law, Congress has a habit of letting certain provisions expire, only to extend/amend them in later tax years. Built-in gains are no exception:For 2009 and 2010, Congress shortened the holding period to seven years.
In 2011 through 2013, the holding period was further shortened to five years.
For 2014 and 2015, the holding period is 10 years.The shorter holding periods of prior years proved beneficial for a great number of companies that were concerned about the traditionally long (10 year) holding period, helping many avoid recognizing gains at a punishing 35%.
Disposing of Assets during the Built in Gains Holding Period with a 1031 Exchange
In the ordinary course of business, companies may need to dispose of existing assets, whether those assets are underutilized, aging fleets, idle or obsolete equipment, or rental assets routinely sold and replaced. Holding on to such assets takes up yard space and triggers unnecessary insurance costs and maintenance fees. Exchanging them through a Section 1031 like-kind exchange (LKE) will protect those built in gains from income recognition (taxation), free up working capital, and significantly increase cash flow to continue growing and expanding operations.
Beyond the Holding Period: The Like-Kind Exchange Program
Implementing a 1031 exchange will not only keep the BIG tax at bay, it can reduce or eliminate other holding costs and secure tax benefits beyond the holding period. It is a little bit like having your cake and eating it too. Asset owners that maintain an LKE program throughout the holding period can permanently avoid the pain of BIG tax and implement a business process that protects them from triggering taxation after the holding period ends.
Absent an ongoing like-kind exchange program, future sales will likely be subject to income taxation (flowing out to S Corp owners). Leveraging a 1031 like-kind exchange program immediately after the conversion provides tremendous cash flow opportunities, as does keeping the program in place thereafter.
Summary
Asset owners, with recent C to S corporation conversions should evaluate their tax positions with their advisors, and consider the potential negative impact of their built-in gains. With the help of a qualified intermediary, owners can project the returns that like-kind exchanges can generate by allowing access to a low cost of capital, deferring gain recognition, and ensuring that their BIG will never get small.Contact us for a free consultation.
-
Section 1031 – Misstatements and Misleading Information
During his campaign, President-elect Trump was criticized for the non-release of income tax returns. The information available is limited to his own statements and the release of three pages from his 1995 returns of income from New York and New Jersey. These pages reveal what amounts to a $900M loss. Unfortunately, these documents are driving misstatements and generating misleading information related to Section 1031 Like-Kind Exchanges – one of the real estate industry’s most popular tax strategies
Misstatements and Misleading Information about 1031 Like-Kind Exchanges
Several articles framed like-kind exchanges in a negative light, including:Washington Post: “How Donald Trump and other real-estate developers pay almost nothing in taxes,” by Max Ehrenfreund, October 4, 2016
Tax Policy Center: “Does Donald Trump pay taxes, ever?” By Steven M. Rosenthal, October 3, 2016 -
Section 1031 – Misstatements and Misleading Information
During his campaign, President-elect Trump was criticized for the non-release of income tax returns. The information available is limited to his own statements and the release of three pages from his 1995 returns of income from New York and New Jersey. These pages reveal what amounts to a $900M loss. Unfortunately, these documents are driving misstatements and generating misleading information related to Section 1031 Like-Kind Exchanges – one of the real estate industry’s most popular tax strategies
Misstatements and Misleading Information about 1031 Like-Kind Exchanges
Several articles framed like-kind exchanges in a negative light, including:Washington Post: “How Donald Trump and other real-estate developers pay almost nothing in taxes,” by Max Ehrenfreund, October 4, 2016
Tax Policy Center: “Does Donald Trump pay taxes, ever?” By Steven M. Rosenthal, October 3, 2016 -
Section 1031 – Misstatements and Misleading Information
During his campaign, President-elect Trump was criticized for the non-release of income tax returns. The information available is limited to his own statements and the release of three pages from his 1995 returns of income from New York and New Jersey. These pages reveal what amounts to a $900M loss. Unfortunately, these documents are driving misstatements and generating misleading information related to Section 1031 Like-Kind Exchanges – one of the real estate industry’s most popular tax strategies
Misstatements and Misleading Information about 1031 Like-Kind Exchanges
Several articles framed like-kind exchanges in a negative light, including:Washington Post: “How Donald Trump and other real-estate developers pay almost nothing in taxes,” by Max Ehrenfreund, October 4, 2016
Tax Policy Center: “Does Donald Trump pay taxes, ever?” By Steven M. Rosenthal, October 3, 2016 -
Is Your 1031 Exchange Straddling Two Tax Years?
Most users of Section 1031 understand the 180-calendar day deadline to complete their like-kind exchange. This general understanding of the exchange period deadline is fine for most transactions, but many exchangers remain unaware of the more nuanced definition of this critical period.
What do the regulations say?
Section 1031’s underlying regulations state, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”
What do the regulations mean?
The regulations generally allow for 180 calendar days for taxpayers to complete their 1031 exchanges that straddle tax years, taxpayers may seek installment tax reporting on IRS Form 6252 in the year of the relinquished property sale. For instance, if the relinquished property closed between November 16 and December 31, the 45-day identification would be in the following calendar year. Similarly, if the relinquished property closed after July 5, and potential replacement property was identified within the 45-day identification period but no replacement property was actually acquired, the end of the exchange period would be in the following calendar year. If the 1031 exchange fails by non-identification or by failure to purchase a replacement property, the sale proceeds would be returned to the exchanger in a different tax reporting year. In this circumstance, the IRS allows taxpayers to either report the gain in the year of sale or in the year the proceeds were received under IRC 453 installment sale rules. This would allow the taxpayer to select the year of reporting that is most beneficial. One might say that a year’s worth of tax deferral is available regardless of the exchange having failed.
Taxpayers Beware
Installment sale treatment generally requires a bona fide intent to complete an exchange. This means that the taxpayer had reason to believe, based on the facts and circumstances at the beginning of the exchange, that a like-kind replacement property would be acquired during the exchange period.
Other installment sale issues:If there was debt paid off at closing of the relinquished property and gain associated with this debt, relief is generally recognized in the year of sale.
Depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale.
Interest is charged on the tax deferred if the sale price of the relinquished property is over $150,000 and certain other instalment obligations exceed $5 million.For taxpayers who have a taxable gain, there is one additional issue to consider. If you are unsettled about current tax rates, you may extend your tax return to report by October 15. This way, you can wait and see if the Congress will change the rates and select the year of reporting that is most beneficial for you.
Check with your tax advisor to determine the correct tax forms and tax extensions to utilize along with the selection of the reporting year for your exchange. -
Is Your 1031 Exchange Straddling Two Tax Years?
Most users of Section 1031 understand the 180-calendar day deadline to complete their like-kind exchange. This general understanding of the exchange period deadline is fine for most transactions, but many exchangers remain unaware of the more nuanced definition of this critical period.
What do the regulations say?
Section 1031’s underlying regulations state, “The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”
What do the regulations mean?
The regulations generally allow for 180 calendar days for taxpayers to complete their 1031 exchanges that straddle tax years, taxpayers may seek installment tax reporting on IRS Form 6252 in the year of the relinquished property sale. For instance, if the relinquished property closed between November 16 and December 31, the 45-day identification would be in the following calendar year. Similarly, if the relinquished property closed after July 5, and potential replacement property was identified within the 45-day identification period but no replacement property was actually acquired, the end of the exchange period would be in the following calendar year. If the 1031 exchange fails by non-identification or by failure to purchase a replacement property, the sale proceeds would be returned to the exchanger in a different tax reporting year. In this circumstance, the IRS allows taxpayers to either report the gain in the year of sale or in the year the proceeds were received under IRC 453 installment sale rules. This would allow the taxpayer to select the year of reporting that is most beneficial. One might say that a year’s worth of tax deferral is available regardless of the exchange having failed.
Taxpayers Beware
Installment sale treatment generally requires a bona fide intent to complete an exchange. This means that the taxpayer had reason to believe, based on the facts and circumstances at the beginning of the exchange, that a like-kind replacement property would be acquired during the exchange period.
Other installment sale issues:If there was debt paid off at closing of the relinquished property and gain associated with this debt, relief is generally recognized in the year of sale.
Depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale.
Interest is charged on the tax deferred if the sale price of the relinquished property is over $150,000 and certain other instalment obligations exceed $5 million.For taxpayers who have a taxable gain, there is one additional issue to consider. If you are unsettled about current tax rates, you may extend your tax return to report by October 15. This way, you can wait and see if the Congress will change the rates and select the year of reporting that is most beneficial for you.
Check with your tax advisor to determine the correct tax forms and tax extensions to utilize along with the selection of the reporting year for your exchange.