This article provides valuable insight into planning for tax deferral, mortage boot and disallowed closing costs.  

 

GIVE TAXES THE  "BOOT"

Proper Planning for Total Tax -Deferral

By Adam Skarsgard, Esq., CPA

One of the most frequently asked questions from clients planning a 1031 Exchange involving real property is,

"How Much Property do I need to purchase to defer all of my taxes? "

A closely related follow question is,

"Which closing costs can I pay for using my exchange proceeds?"  

These are two very good, very important and sometimes very challenging questions.  However, using simple rules of thumb can help clients condense and better comprehend the issues of taxable exchange boot.  Although not a substitute for professional tax advice, this article will attempt to provide a pocket guide for investors planning an exchange with the goal of total tax-deferral.  

What is Exchange boot?

The term exchange "boot" refers to anything of value recieved by an exchanger that is not like-kind to the property sold in the exchange.  boot is the enemy of exchangers attempting to perform a totally tax deferred exchange as it will almost always result in a taxable gain.  there are three forms of exchange boot that are most common in real estate exchanges : cash, mortgage and disallowed closing costs.  

Cash is the easiest to explain and therefore to avoid.  If a seller receives cash from a sale or exchange, it will be taxable.  Unfortunately, there is no way to avoid taxes on cash received.  This includes the cash originally used as a down payment on the property being sold.  Exchangers should stay away from receiving cash in an exchange unless they are willing to pay taxes on the amount received . Qualified intermediaries will help exchangers in avoiding cash boot.

The other two most common types of boot, mortgage and disallowed closing costs, are more complicated and therefore will require a separate and more lengthy examination.

Mortgage Boot

Mortgage boot is the net reduction in loans secured by the relinquished property vs. loans secured by the replacement property.  If the property sold had loans secured by the property equaling 500,000 and the property purchased had loans secured by the property equaling 400,000 the 100,000 difference is mortgage boot.  As mentioned in the section above, boot is anything of value reviewed by the exchanger.  Debt reduction is valuable and thus constitutes boot.

However, unlike cash, mortgage boot is not always taxable.  An exchanger can reduce their loans from one property to the next as long s they make up for the difference with cash out f pocket.  Using the example from this section, if the exchangers with 100,000 in mortgage boot contributes an additional 100,000 in cash, out of pocket, into the property purchased, it will make up for the mortgage boot and no tax will be incurred.  

The rule of thumb for total tax-deferral is to use all of your exchange proceeds to purchase the new property and purchase a property that is equal or greater in value to the property that was sold.  If an exchanger ""uses all of their exchange cash" and "trades equal or up in value" no taxes will be incurred in the exchange.  

Disallowed Closing Costs

Closing costs are all costs required for the sale or purchase of property.  Some closing costs can be paid for with exchange proceeds without incurring a tax.  Other should not be paid for using exchange funds and if done would be the equivalent of receiving cash boot and would therefore be taxable.  In order to properly analyze whether such costs can be paid for with exchange funds without incurring a tax, it is best to separate the costs into two categories.  First are costs that are non-recurring and specifically related to the closing.  Such costs can generally paid for by using exchange proceeds and will reduce the property's net sales price for sellers or increase the net purchase price for buyers.  A partial list of such costs includes:

• Sales commissions
• Title and escrow fees
• Recording fees
• transfer taxes
• 1031 Exchange Qualifies
• Intermediary fees

The second category of items include the costs that are either recurring or do not specifically relate to the closing.  Such costs should not be paid for using exchange proceeds as it may result in a tax liability.  Such costs should be paid for by the exchangers out of pocket and not with exchange proceeds.  These costs also do not decrease the net sales price or increase the net purchase price.  A partial list of such costs includes:

• mortgage boot interest and interest
•  rate buy downs
• mortgage boot prepayment penalties
• all prorated expenses, including property taxes, utilities, homeowner's fees and insurance expenses.

Conclusion.  

An investor involved in an exchange should always discuss the issue of a taxable boot with their tax advisor.  Hopefully, this article has provided some rules of thumb that will make taxpayers more knowledgeable when discussing the matter and planning their exchange with tax counsel. 

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    Spring is almost here! Don't forget to set your clocks forward 1 hour on March 9th. With the beautiful weather approaching, now is a perfect time to think about buying or selling. Listing a home now is perfect timing - the months just before spring are the times when people are looking for homes on the market.

  Housing in our current market is hard to gauge if you go some of the news in the real estate section.  According to the Associated Press, housing resales were down last month.  However, when we look a little closer at the numbers themselves, we find that resales for detached single family homes actually went UP in January, where the sales of condos and cooperatives went down - and that dragged down the national sales total overall a bit. 

    So what is the real news? The market is improving as predicted.  Last week, the market showed even more signs of improvement - construction of new houses is on the rise, and with the house price declines and interest rate cuts, it looks like the predicted turnaround in the market is on its way this Spring!

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Happy New Year! 2008 is going to be an interesting year for real estate. There are a number of economic factors at play as well as a media which loves to predict doom and gloom.

Mortgage interest rates are currently very low.

30 Year Fixed: 6.07%
15 Year Fixed: 5.68%
1 Year Adjust: 5.47%

Interest rates might even go lower if the Federal Reserve drops short term rates by another half point as expected later this month.
On other economic news, unemployment rates jumped a bit in December which caused a stir in the stock market. Existing home sales rose 4/10% showing very modest growth. The current expectation is that we will begin to see a very slow recovery starting in the Spring. It is currently a buyers market so it might be a good time to look for a second home or move up by renting your existing home and purchasing a new home. With low interest rates, a buyers advantage, and good inventory, now might be a good time to act before market becomes extremely competitive as it has been over the last several years.
If you or anyone you know have any real estate questions or needs please feel free to call or e-mail me.

Please feel free to post any comments on your Real Estate predictions this year.

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