Avoiding The Boot
One snare that can cause
these deals to run afoul of the IRS is a boot. This consists of either a cash
gain or a reduction in debt on a property. Says Schooley: “If you walk away from
a swap—whether at the first closing or after the completion of the swap—and you
have cash in your pocket, that’s a taxable boot.” A liability boot, in which
debt is reduced when a debt-laden property is swapped for one with a lower
price, is another wrinkle to avoid. If, for example, an investor sells a $1
million property that carries $500,000 of debt, then buys an $800,000 property
with $300,000 in debt, though the sale does not generate cash, it does pay down
the original debt. “That is a liability boot, and it is taxable,” notes
Schooley, who is CEO of 1031 Accommodators LLC, a firm that acts as a middleman
for these deals—usually for a fee of 1 percent to 2 percent of the value of the
relinquished property.“The investor who is exchanging his property cannot
get his hands on any of the money during the whole swap process,” says Frank
Kovats, director of Kovats Real Estate and Insurance School in Maywood, N.J. “If
he does, he’s disqualified from deferring any taxes.” When investors decide that
they are going to sell their investment properties, they enter into a contract
to sell them to buyers, who turn around and assign the contract to a third party
called the qualified intermediary. All money placed in swapped properties is
channeled through the intermediary. When the investor locates a replacement
property, he enters into a contract to purchase it, and the qualified
intermediary enters the picture. Choosing a competent qualified intermediary
is crucial. They are not licensed, as are brokers. Obtain recommendations from
the intermediary’s former clients, Kovats advises. Then ask a litany of
questions. How long has the intermediary handled trust accounts? In how many
transactions has he or she been involved? What were the dollar amounts of the transactions? “In some cases the qualified intermediary might not charge a very
large fee, but he might say that he has the right to retain the interest that’s
earned on the money he holds during the course of the transaction,” Kovats
warns. “If he wasn’t willing to discuss these things with me, that would be a
red flag; I’d move on.”
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