Exchanging can seem deceptively easy. That does not mean the tax consequences are transparent or easily understood.
The mechanics of an exchange, especially if you use an experienced intermediary can seem deceptively simple. However, the tax consequences and the planning required to maximize the tax benefits of an exchange are complex. Here are a few of the traps which can trip the un-informed.
Boot is a rather inelegant exchange term which means non-like-kind property. Anything of value which a taxpayer receives in an exchange, other than like-kind property is boot. Boot is taxable. When a taxpayer has a reduction of debt as a result of an exchange, the reduction is a “thing of value” received during the exchange and is thus a particular kind of “boot” known as “mortgage boot”. Mortgage boot received by a taxpayer in an exchange is taxable.
For example: suppose a taxpayer sells a property (“relinquished property”) with a value of $100,000 encumbered by a mortgage of $60,000. The taxpayer acquires a $90,000 replacement property using $40,000 cash received from the relinquished property and a loan of $50,000. The taxpayer has a reduction in debt from $60,000 to $50,000 which is mortgage boot and taxable to the taxpayer.
Property Identification Violations
A taxpayer has 45 days after closing of the sale of relinquished property to identify replacement property. After the 45 day identification period, the identified property is the only property qualified as replacement property. Failure to identify replacement property during the 45 day period will cause the exchange to fail and result in taxation of the gain.
There are other identification traps which can cause problems. For instance, assume a taxpayer intends to acquire a 50% interest in replacement property and own it jointly with another party. If the taxpayer identifies all of the property as replacement property rather than a 50% interest, the identification may be defective and result in taxation.
Failure to properly identify replacement property can result in a defective identification. For instance, if a taxpayer intends to purchase a 50 acre ranch as replacement property, identifying “50 acres in Travis County, Texas” is probably insufficient because it does not sufficiently describe the replacement property.
Holding Period Violations
Other than exchanges with related parties, there is no statutory period of time specified during which a taxpayer must hold replacement property before a second disposition. The taxpayer must be able to prove that property was acquired for investment or for productive use in a trade or business.
If replacement property is sold too quickly, the IRS may argue that the property was acquired for re-sale rather than for investment or for use in a trade or business. If replacement property is held for a year, there is little chance that the IRS will challenge the exchange due to a holding period violation. However, this is not an absolute rule. The issue is determined by the intent of the taxpayer at the time the replacement property was acquired. The intent must be to hold the property for investment or for use in a trade or business.
Recapture Of Accelerated Deprecation
There are certain instances when the depreciation of property can be accelerated. If accelerated depreciation has been taken on relinquished property, an exchange, in some limited circumstances, can trigger re-capture of accelerated depreciation. If you have taken accelerated depreciation on relinquished property, you should consult with your accountant when planning an exchange to make certain there will be no last minute tax surprises.