In Chief Counsel Advice 201325011 the IRS concluded that a taxpayer's exchange qualified as a like-kind exchange under code sec. 1031, and that the taxpayer didn't have actual or constructive receipt of the relinquished property (RQ) sales proceeds under Reg. § 1.1031(k)-1. In the exchange, the RQ was security for lines of credit used to purchase the RQ and for general business operations. The taxpayer's qualified intermediary (QI) was required to use the proceeds to pay down amounts that the taxpayer owed on the lines of credit.
The Taxpayer, who rented equipment to customers engaged in a Like Kind Exchange (LKE) in 2003 to defer the recognition of gain from the sale of its rental equipment. The Taxpayer entered into a Master Exchange Agreement (MEA) with a QI to engage in these multiple exchanges in its LKE program. Under the MEA, the QI acquired the RQ from Taxpayer, transfered the RQ, acquired the replacement property (RP) and transfered the RP to Taxpayer. In the MEA, Taxpayer make a blanket assignment of its rights under sale and purchase contracts to the QI and provided for written notification of the assignment to all parties.
The Taxpayer maintained lines of credit with two creditors. The proceeds from the lines of credit were used to purchase RP. However, Taxpayer also uses the proceeds from these lines of credit for other business purposes, not just the acquisition of RP.
Under its agreements with these creditors, all rental properties, including properties relinquished and acquired in the Code Sec. 1031 exchange as RQ and RP, secured the outstanding balances on the lines of credit from the time Taxpayer acquired the property until it was sold. The outstanding balances on the lines of credit were also secured by Taxpayer's accounts receivable and new equipment held by Taxpayer for sale in the ordinary course of business. All property was separately listed as collateral for one or the other, but not both, of the lines of credit. The full value of the rental property secured the entire outstanding balances on the lines of credit.
The MEA provided that Taxpayer didn’t have the right to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by the QI. The MEA also provided that the QI must use the proceeds from the sale of RQ to the pay down Taxpayer's outstanding balances on the lines of credit. Accordingly, the proceeds from the disposition of RQ as part of any exchange under the MEA were deposited directly into a joint QI/Taxpayer account and then immediately disbursed by the QI to satisfy Taxpayer's obligation on one or the other line of credit. Under this arrangement, Taxpayer uses borrowed funds to acquire RP and complete its exchanges.
The IRS field attorney argued that the debt pay-down arrangement resulted in Taxpayer actually or constructively receiving the RQ proceeds before the end of the exchange period. As a result, Taxpayer couldn't defer the gain realized on its transfers of RQ under Code Sec. 1031(a).
Rejecting the field attorney's position, IRS concluded that Taxpayer's exchange would qualify as like-kind exchanges under Code Sec. 1031 if Taxpayer otherwise met the requirements of Code Sec. 1031 . The fact that the RQ debt is used not only to purchase RQ but also for general business operations and that the QI uses the RQ proceeds to pay down Taxpayer's lines of credit, didn’t result in Taxpayer being in actual or constructive receipt of the RQ proceeds under Reg. § 1.1031(k)-1.
In the present case, the proceeds from the disposition of the RQ were paid to the joint account controlled by Taxpayer and the QI. The QI then disbursed the RQ proceeds to pay down the debt on the Taxpayer's lines of credit, as required by the agreement with Taxpayer's lenders. The Taxpayer then acquired RP by financing the acquisition with new debt in an amount that equaled or exceeded the debt that encumbered the RQ.
Under its arrangements with the QI and its lenders, the QI was required to use the RQ proceeds, but not proceeds from its accounts receivable and new equipment sales, to pay down lines of credit.
The IRS noted that the facts in Taxpayer's case were similar to those in Reg. § 1.1031(k)-1(j)(3), Ex. 5. (see below)
In the Taxpayer's case, the debt that was secured by the RQ was incurred not only to purchase RQ but also for general business operations. In contrast, Reg. § 1.1031(k)-1(j)(3), Ex. 5, provided only that the RQ was "encumbered by a mortgage of $30,000" and didn’t discuss when or why the property was encumbered. However, the result in the reg example 5 would not change if the debt was incurred as a result of a refinancing of the RQ, the proceeds of which were used for general business operations. The CCA was unaware of any authority for making a distinction along the lines of the purpose of the encumbrance or whether the taxpayer used the proceeds for more than the purchase of RQ. Accordingly, the fact that the debt in Taxpayer's case was incurred for more than the acquisition of the RQ would not result in actual or constructive receipt of the RQ proceeds when the QI pays off the RQ debt.
Further, the fact that the QI useed the RQ proceeds to pay down the RQ debt, rather assumed the RQ debt as in Reg. § 1.1031(k)-1(j)(3), Ex. 5, did not result in actual or constructive receipt of the RQ proceeds.
In Barker, 74 TC 555 (1980), the Tax Court held that proceeds from the disposition of RQ can be used to pay off debt on the RQ without triggering gain if the taxpayer incurs or assumes a liability on the purchase of RP that equals or exceeds the debt on the RQ. Thus, the Tax Court held that the boot netting principle in Reg. § 1.1031(b)-1(c) covers not just assumptions of debt but also situations in which the proceeds of the RQ are used to pay off RQ debt.
BOOT NETTING RULE
In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. Code sec. 1031. Qualified intermediaries (QIs) may be used to structure deferred like-kind exchanges using qualified exchange accommodation arrangements.
( Reg. § 1.1031(k)-1(g)(4) )
Under Reg. § 1.1031(k)-1(f)(1), gain or loss may be recognized in the transfer of relinquished property in a deferred exchange if the taxpayer actually or constructively receives money or other property before the taxpayer actually receives like-kind replacement property.
Under Code Sec. 1031(b), in an exchange that would otherwise be within Code Sec. 1031(a) if not for the fact that the property received in the exchange includes non like-kind property or money, the gain (if any) to the recipient must be recognized, but in an amount not in excess of the sum of the money and the fair market value of the non like-kind property. Under Reg. § 1.1031(b)-1(c), consideration in the form of an assumption of liabilities (or a transfer subject to a liability) is treated as "other property or money" for this purpose. If each party either assumes a liability of the other party or acquires property subject to a liability, then, in determining the amount of other property or money, consideration given in the form of an assumption of liabilities (or the receipt of property subject to a liability) is offset against consideration received in the form of an assumption of liability (or transfer subject to a liability).
Thus, when there are mortgages on both sides of the transaction, the mortgages are netted and the difference is recognized gain (boot) to the party transferring the property subject to the larger mortgage.
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