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IRS presents taxpayer-friendly view of what constitutes constructive receipt of proceeds in a like-kind exchange

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by: Mike Rosenberg, CPA, Retired Partner

The tax and financial benefits of a likekind exchange of real estate are well known to property owners. A properly structured exchange allows a seller of property to defer gain recognition on the sale, and reinvest pre-tax dollars into a larger portfolio of assets.

However, a seller must trade up not only in value, but also in equity to defer all the gain in an exchange. This means that the seller cannot take cash out of the exchange at closing by incurring a debt on the replacement property greater than the debt on the property sold (relinquished), thereby substituting new debt for exchange equity. For example, an exchange of a property with a value of $10 million, a mortgage of $5 million, and equity of $5 million for a new property valued at $12 million on which a mortgage loan of $8 million is placed, will result in recognition of gain on the $1 million cash taken out of the exchange.

Most often, the seller will obtain new bank financing to acquire the replacement property. Likewise, the buyer of the relinquished property will obtain new financing, and the seller’s mortgage on the relinquished property will be paid off at closing. Because the seller is contractually obligated to pay off the mortgage on the relinquished property, the seller is not considered to have received taxable proceeds in the exchange. Essentially, the seller is permitted to net liabilities in the exchange – as long as the new debt incurred in the acquisition of the replacement property is equal to or greater than the debt paid off on the relinquished property.

Under the above rule unsecured liabilities may be netted against secured or unsecured liabilities, and there is no express requirement that unsecured liabilities are to be paid off as part of the exchange related to the relinquished property. However, any unsecured liabilities paid from the exchange proceeds should relate to the relinquished property. Otherwise, the seller may be deemed to have received taxable proceeds in the exchange.

This can be a problem where the relinquished property secures an umbrella loan that is also secured by several other properties. The seller may want to use the exchange proceeds to pay down the umbrella loan rather than just the release price set forth in the loan documents. A cautious approach has been for the seller to obtain a demand letter from the lender requesting all of the proceeds from the sale of the relinquished property to avoid an IRS argument that the seller is in effect receiving cash proceeds on the sale and voluntarily paying down the umbrella loan.

The IRS, in Chief Counsel Advice (CCA) 201325011, presented a taxpayer-friendly view on this matter and concluded that relinquished property sale proceeds in a like-kind exchange used to pay off debt (a line of credit) originally incurred for the acquisition of the relinquished property and other purposes did not result in a deemed taxable receipt of cash from the sale of the relinquished property. In this regard, the IRS made no distinction along the lines of the purpose of the encumbrance by the loan paid off or whether the seller used the loan proceeds for more than the purchase (or refinance) of the relinquished property.

A Chief Counsel Advice is issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues. While it cannot be used as precedent, it provides an indication as to how the IRS might view a situation with similar facts.

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