AVOIDING TAXABLE “BOOT”

As you may know, “boot” is the term applied when anything of value is received by the taxpayer (the exchanger) in an exchange. Cash is the easiest form of boot to recognize, but boot can take other forms, too. Say the buyer offered you $480,000 plus his 1961 Chevy Impala for your property—the Chevy’s value is likely going to be boot without some fancy finagling to work around it. In addition to Chevys and cash, there can be other ways in which boot can be created unwittingly. With a little foresight, though, that can be avoided.

When a typical real estate transaction involving investment property closes, credits from one party to the other often appear on the settlement statement. If rents have been collected in advance, for instance, the seller might owe the buyer credit for the period of time the rent covers after the seller no longer owns the property. Security deposits are often treated as a credit to the buyer as well. In an exchange, however, such credits are considered income items and cannot be offset against gain that would otherwise be deferred.

How about an example?

It’s often more easily understood by way of example. Let’s assume that a taxpayer is selling a multi-unit apartment building as relinquished property in an exchange for $600,000. He has collected $20,000 in “prepaid rent,” or rent for the time during which he will no longer own the property. In addition, he is holding $15,000 in security deposits that must be transferred to the new buyer since reconciling those deposits becomes the new buyer’s obligation when he takes ownership of the property. To simplify matters, let’s disregard all closing costs and assume there is no mortgage. The $35,000 in prepaid rent and deposits, if simply credited against the sale price of the property, is considered boot and can’t be offset against the gain.

Is there a solution?

Yes, in fact, it’s simple. Just transfer amounts for those items outside of closing, directly from the seller to the buyer.

What about prorating property taxes? Does that create the same problem?

As with prepaid rents and security deposits, the standard way of handling property taxes is for the seller to provide a credit on the settlement statement for amounts that will be due in the future but actually cover time during which the seller has owned the property. However, property taxes are treated differently than deposits and rent prorations. Property tax prorations are treated similarly to how debt is handled —as a liability of the property. Just as the relief of debt paid off on the relinquished property can be offset by equal or greater debt on the new property (or the infusion of cash), the relief of the tax liability can be offset by an equal or greater credit from the seller of the property acquired in the exchange on the settlement statement for that transaction.

How about the replacement property?

Essentially, the same issues apply to the replacement property as apply to the relinquished property. Ideally, you will want the seller to provide any credits for prepaid rents and/or security deposits directly to you outside of closing.

If you have questions about these issues, please feel welcome to contact us.