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BOOT AND BASIS

It is a common misconception among investors and practitioners that only the "gain" realized on the sale of the property needs to be re-invested into replacement property to achieve tax-deferral. Not so. The fail-safe rule that should result in total tax deferral is: trade even or up in cash and even or up in value.

The Regulations provide that, if an exchange would be within the provisions of 1031(a) except for the fact that the property received consists of qualifying property and other property or money, the gain, if any, to the recipient is recognized to the extent of the sum of money and the fair market value of "other property" received.

This "money or other property" is commonly called "boot" and includes liabilities assumed or attaching to property received in an exchange.

"Other Property" is either property specifically excluded (stock in trade, notes, choses in action, partnership interests, etc.) or property which is not of like-kind with property surrendered in the exchange.

Consideration given in the form of cash or other property is netted against consideration received in the form of an assumption of a liability or a transfer of property subject to a liability.

Consideration received in the form of cash or other property is not, however, netted against consideration given in the form of an assumption of liabilities or a receipt of property subject to a liability.

BOOT NETTING RULES

• Cash paid on the acquisition of replacement property offsets cash received on the disposition of relinquished property.
• Cash paid on the acquisition of replacement property offsets debt relief on the disposition of relinquished property.
• Debt assumed on the acquisition of replacement property offsets debt relief on the disposition of relinquished property.
• Debt assumed on the acquisition of replacement property will not offset cash received on the disposition of relinquished property.

Code §1031(b), (c), Reg. §1.1031(a)-1, (b)-1, (d)-1, (d)-2.

This issue often arises in the following situation: Taxpayer has entered into a contract for sale of his property and:

(i) the buyer has deposited earnest money into a bona-fide escrow or

(ii) the buyer has given an earnest money deposit directly to the Taxpayer or to Taxpayer's attorney or agent who has a legally binding obligation to return the deposit if the sale does not close.

The assumption in both situations is that the earnest money deposit would be treated as a "deposit" for federal income tax purposes.

The first situation is relatively straightforward and should not result in constructive receipt by the Taxpayer. There is a significant amount of authority holding that a Taxpayer/seller is not in constructive receipt of earnest money deposits held by an escrow agent in connection with the sale of property. See e.g., Johnston v. Commissioner, 14 T.C. 560 (1950) and also PLR 8915032 infra.

The second situation presents a somewhat more complex issue because the Section 1031 Regulations literally provide that a Taxpayer will be considered to have received boot if he is in actual receipt of cash. Reg. Section 1.1031(k) - 1(f)(1). Nevertheless, the law is clear that no taxable event occurs as a result of a seller of property receiving an earnest money deposit, at least where there is a legal obligation to return the deposit to the purchaser if the transaction does not close (for reasons other than the default of the purchaser). See e.g., Baird v. United States 65 F.2d 911, 12 AFTR 896 (5th Cir. 1933), cert. denied, 290 U.S. 690 (1933). Given such analogous authority, the IRS could conclude that under such circumstances the receipt by the Taxpayer of the deposit does not result in actual or constructive receipt for purpose of Reg. Section 1.1031(k)-1(f). See also LTR 8118014 (Jan. 30, 1981). Since the literal words of the new Section 1031 Regulations might imply that any receipt of cash constitutes boot, this clarification may have to be made by way of an amendment to the Regulations.

Taxpayer has realized gain of $30,000 on the disposition of relinquished property but is required to recognize gain of only $10,000, cash received in the exchange.

Taxpayer has realized gain of $50,000 on the disposition of relinquished property but is required to recognize gain of only $24,000 net debt relief.

SUBSTITUTE BASIS COMPUTATION

The basis of property received in an exchange is equal to the adjusted basis of property surrendered plus the net increase or minus the net decrease in debt, minus the net cash received or plus the net cash paid, plus the amount of gain recognized in the exchange. This is known as "substitute basis".

Code §1031(d), Reg. §1.1031(d)-1.