It is often assumed that if a taxpayer receives cash in a tax-free exchange, the cash must be boot. It can be quite frustrating when a replacement property-lender requires that reserves be funded at closing, and funding those reserves with cash creates taxable boot. Strategies that fund the reserves without creating taxable boot are discussed below.
In the "black box" approach to exchange transactions, the taxpayer throws real estate and a new loan into the accommodator's black box and receives back real estate, the payoff of the old loan on the relinquished property, and perhaps a few other assets such as funded reserves. The bank often requires these reserves in order to pay for identified repairs to the property or to fund operating deficits. Since the funded cash reserves are not real estate, they are not like kind to the relinquished property and thus must be boot.
The black box theory often succeeds in predicting tax results, but not always. It probably makes more sense to look at exactly how the Internal Revenue Code works in this area. Cash boot received by a taxpayer cannot be offset by assuming indebtedness on the replacement property or acquiring the replacement property subject to indebtedness. Treas Reg § 1.1031(d)-2. Thus, the IRS’s position is that if you receive cash boot in a transaction (which would include funded reserve accounts), you cannot claim that it is not taxable because the boot should not be taxed to the extent that the taxpayer took on more debt in the exchange transaction.
As a practical matter in a typical exchange, the purchase of the replacement property and funding reserves are completed in an escrow containing both loan proceeds and accommodator funds that were placed with the accommodator ("Exchange Proceeds") on the sale of the relinquished property. When the transaction is closed and the reserves are funded, there is no grounds to take the position that the reserves were funded from loan proceeds rather than Exchange Proceeds. Further, one cannot claim that the reserves were (i) funded with loan proceeds and Exchange Proceeds on a prorated basis, or (ii) that the reserves were funded only with loan proceeds.
One solution to this vexing problem would be a lender’s willingness to accept a letter of credit in lieu of reserves. But this solution, however effective, is often impractical. Another effective approach is to fund the reserves post-closing with new cash from the taxpayer or with the proceeds of a separate loan.
Other solutions focus on splitting into two separate transactions the loan transaction to fund the reserves and the loan transaction to complete the exchange. No one can argue with the general principle that the receipt of loan proceeds does not create taxable income. The IRS has been unsuccessful in taking the position that the receipt of loan proceeds following an exchange should be treated as taxable boot. See Frederick W. Behrens, 54 TCM (P‑H) ¶ 85,195 (1985); Franklin B. Biggs, 69 TC 905 (1978), aff'd, 632 F2d 1171 (5th Cir 1980); Treas Reg §1.1031(k)-1(j)(3), Ex. 2. Some of the approaches described below rely on tracing concepts to make it clear that the reserve funds were funded only with loan proceeds and not with Exchange Proceeds.
The following techniques are suggested ways to split the loan transaction funding the reserves from the exchange transaction:
- Instruct the lender to not disburse the loan proceeds used to fund reserves through escrow; instead, have the funds transferred directly to the bank account where the reserves are to be held.
- Have the lender fund the reserves after the exchange has closed. It will then be clear that the reserve funds were used to fund the reserves, not to purchase the replacement property.
- Have the lender fund the reserves through a separate escrow that is used for that sole purpose.
The body of case law and rulings that analyze this issue is quite limited. It is possible that the IRS may not agree that funding lender-required reserves using any of the above three techniques does not result in taxable boot.
Nevertheless, there is a sound theoretical basis that if any of these approaches is taken, taxable boot can be avoided.