Financing Issues and Techniques
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
This section addresses what is counted as a “liability” for purposes of Section 1031. This issue
determines whether an item is treated as cash boot or as a liability for purposes of the Section
1031 boot netting rules. Under these netting rules, liabilities assumed by the taxpayer do not
offset cash boot received but do offset liabilities that the taxpayer is relieved of. Thus, the
determination of whether an item is treated as a liability is crucial to determine the amount of
boot received and the gain recognized on an exchange. This determination also affects the tax
treatment of so-called pay-down, pay-up transactions, other forms of financing, and pre-
exchange and post-exchange refinancing. In each case the question is whether the taxpayer has,
in substance, received cash boot in an exchange or incurred a genuine liability for purposes of
Section 1031. If the liability is respected, it may be offset under the liability netting rules (e.g.,
pre-exchange liabilities) and/or be treated as separate from the exchange and simply as a tax-free
borrowing (e.g., post-exchange liabilities).
Section 1031(d) provides that a liability will be considered assumed for purposes of Section 1031
if it meets the definition of a liability assumed for purposes of Section 357(d). Section 357(d)
determines the amount of liabilities assumed as: (1) a recourse liability (or portion thereof) is
treated as having been assumed if, as determined on the basis of all facts and circumstances the
transferee has agreed to and is expected to satisfy such liability (or portion) whether or not the
transferor has been relieved of such liability; and (2) a non-recourse liability is treated as
assumed by the transferee of any asset subject to such liability, except that the amount of a non-
recourse liability shall be reduced by the lesser of (i) the amount of such liability which an owner
of other assets not transferred to the transferee and also subject to such liability has agreed with
the transferee to, and is expected to, satisfy or (ii) the fair market value of such other assets
(determined without regard to Section 7701(g) which provides that the fair market is deemed to
equal the amount of the non-recourse debt).
The legislative history of Section 357(d) further states that if a transferee corporation does not
formally assume a recourse obligation or potential obligation of the transferor, but instead agrees
and is expected to indemnify the transferor with respect to all or a portion of such an obligation,
then the amount that is agreed to be indemnified is treated as assumed for purposes of the
provision, whether or not the transferor has been relieved of such liability. H. Rep. No. 1033,
106th Cong., 2d. Sess. (P.O. 106-554). Thus, when a relinquished property transferee agrees to
take on the primary responsibility to pay an exchanger's recourse liability, that liability should be
considered assumed and part of the sale consideration. This is the result whether or not the
transferee formally assumes the recourse obligation but instead agrees and is expected to
indemnify the exchanger with respect to this obligation. This is in contrast to the rule for non-
recourse debt, which states that a debt is considered assumed on the transfer of property which is
subject to the liability.
Debt secured by the taxpayer's relinquished property or debt secured by the replacement property
clearly are “liabilities” to which the liability netting rule applies. See Reg. Section 1.1031(d)-2.
These liabilities are not, however, the only forms of debt to which the rule applies. In TAM
8328011 the IRS determined that non-mortgage liabilities are netted against mortgage liabilities
under Section 1031 and that items listed in the escrow account that "relate to sums certain, due at
a fixed or determinable date of maturity," are liabilities for purposes of Section 1031. Reg.
Section 1.1031(j)-1(b)(2)(ii) provides that all liabilities assumed by the transferee are taken into
account under the multiple property rules, regardless of whether they are secured or not secured,
or whether they relate in any way to the assets transferred. In the preamble to proposed
regulations, the Service stated that all liabilities from which the taxpayer is relieved in an
exchange are offset against all liabilities assumed by the taxpayer in the exchange, regardless of
whether the liabilities are recourse or non-recourse and regardless of whether the liabilities are
secured by or otherwise relate to the specific property transferred or received as part of the
exchange. IA-12-89, 1990-1 CB 656.
As noted above, the issue of what is counted as a “liability” under Section 1031 is important in
determining whether the taxpayer has received boot and, if so, how much boot. The taxpayer
must recognize gain in the amount of the money or other property (“boot”) received under
Section 1031(b), even though the exchange otherwise qualifies under Section 1031(a). If the item
is not a liability, it will be treated as cash boot received. Liabilities incurred to acquire the
replacement property do not offset cash boot received. Reg. Section 1.1031(d)-2, Example 2. It is
clear that mortgage liabilities encumbering the relinquished or replacement properties are
generally counted as “liabilities” and offset each other for purposes of Section 1031. The only
exceptions are where the mortgage simply secures another person’s liability and the taxpayer
does not bear the economic risk of loss. In PLR 7935126 (June 4, 1979), the taxpayer simply
retained a security interest in the relinquished property to secure the promise of the transferee to
pay off the transferee’s liability encumbering the replacement property. The Service disregarded
the encumbrances because they were not part of the consideration received or given in the
exchange. The transferee remained liable on the replacement property mortgage after the
property was transferred to the taxpayer. The security interest retained by the taxpayer in the
relinquished property was merely collateral to ensure that the transferee paid off its retained
mortgage debt. The Service held that such a security device was not akin to a purchase money
note received by a seller.
Mortgage liabilities should be treated as part of the consideration received or given in an
exchange if they are reckoned with by the parties. For example, a mortgage liability is typically
taken into account by the parties in determining any cash or other consideration or the “exchange
credit” due to a party. The mortgage liability then must be paid off, incurred or assumed (or the
property must be acquired subject to the liability) so that the exchange occurs on the agreed
terms. Of course, the parties are free to effect exchanges where mortgage liabilities are not part
of the consideration received or given in the exchange. A party can cause the lender to shift the
mortgage to another property or pay off the loan with his own funds before closing. A party can
also remain liable and bear the economic risk of loss for a mortgage after transferring the
property, like the transferee in PLR 7935126. But these cases are unusual.
In TAM 832801, the Service concluded that (1) non-mortgage liabilities should be netted with
mortgage liabilities in determining recognized gain under Section 1031(b); and (2) “items listed
in the escrow account that relate to sums certain, due at a fixed or determinable date of maturity,
are liabilities for purposes of section 1031 of the Code.” The TAM specifically ruled that (1) five
items of “interest” were presumably liabilities of the taxpayer that could be netted, and (2) the
rent proration and tenant deposits were not liabilities and could not be netted based on Rev. Rul.
73-301, 1973-2 C.B. 215 (which held that deferred credits, representing prepaid income, should
not be treated as liabilities for purposes of Section 752) and Rev. Rul. 75-363, 1975-2 C.B. 463
(which held that a security deposit is generally treated as a grantor trust subject to Section 671
since the landlord is a fiduciary, as opposed to a creditor, with respect to that deposit). The TAM
was issued before the amendment to Section 1031(d) that now defines liabilities assumed by
reference to Section 357(d). Thus, the TAM does not address whether prepaid rent and security
deposits may be treated as “liabilities” under Section 357(d) and thus for purposes of Section
1031(d). The treatment of these amounts under state and local law may also be relevant in
determining whether the landlord is considered a fiduciary or a creditor with respect to prepaid
rent and tenant security deposits. See Long v. Commissioner, 77 T.C. 1045 (1981) (security
deposits included as liabilities in court’s computation of net liability relief).
TAM 8328011 is interesting for its broad definition of a “liability.” Items listed in the escrow
account that relate to sums certain, due at a fixed or determinable date of maturity, are liabilities
for purposes of Section 1031, even if they are not secured by a mortgage or other lien on the
exchanged properties. Many non-mortgage items literally satisfy this definition, such as
unsecured loans, accrued property taxes, assessments, utility bills, management contracts, service
contracts, amounts due to contractors, repair bills, insurance payable, rent payable, other
accounts payable and all other obligations of a certain amount with a determinable due date.
Unlike Section 357(c), these liabilities appear to be taken into account under Section 1031 even
if they give rise to a deduction when paid. But the TAM applies this definition in an unclear way.
Interest, a late charge and a “trust fund deficit” are treated as liabilities but some or all of these
items may in fact have been secured by a mortgage. The definition of “liabilities” in the TAM
may also exclude contingent or indefinite liabilities where either the amount or the due date is
uncertain. Compare Reg. Sections 1.752-2(b)(4) and 1.752-2(f), Example 8. Reg. Section 1.752-
2(b)(4) provides that “if a payment obligation would arise at a future time after the occurrence of
an event that is not determinable with reasonable certainty, the obligation is ignored until the
A broad definition of the term “liabilities” is consistent with Reg. Section 1.1031(j)-
1(b)(2)(ii)(A) which applies to an exchange of multiple properties. That regulation states: “All
liabilities assumed by the taxpayer as part of the exchange are offset against all liabilities of
which the taxpayer is relieved or part of the exchange, regardless of whether the liabilities are
recourse or non-recourse and regardless of whether the liabilities are secured by or otherwise
relate to specific property transferred or received as part of the exchange.” The term is also
broadly defined for financial accounting purposes. For such purposes, prepaid income, customer
and other deposits, accrued expenses, accounts payable and notes payable are treated as
liabilities. Some of the cases involving exchanges of partnership interests prior to the enactment
of Section 1031(a)(2)(D) examined the financial statements of the partnerships and applied the
broad definition of a “liability.” See Long v. Commissioner, supra (tenant deposits, note payable,
payable to land management account, partner advances and mortgages treated as liabilities);
Miller v. United States, 63-2 USTC Par. 9606 (S.D. Ind. 1963) (accounts payable, notes payable,
accrued expenses, mortgages payable and other liabilities treated as liabilities, with only the
property not of like kind treated as boot).
Although the term “liability” is a broad one, and although non-mortgage liabilities are counted
under the TAM and Reg. Section 1.1031(j)-1(b)(2)(ii)(A), the liability must be assumed as part
of the exchange in order to be taken into account under the netting rule. See the last sentence of
Section 1031(d); Reg. Section 1.1031(d)-2 (referring to liabilities that are “part of the
consideration to the taxpayer”); Reg. Section 1.1031(b)-1(c) (referring to “consideration
received” and “consideration given”). Obviously, this requirement rules out liabilities that are not
part of the consideration received or given in the exchange, such as the mortgage retained by the
transferee in PLR 7935126. But does it do more than this?
In a world of two-party simultaneous exchanges without due-on-transfer provisions in mortgages
(the world for which the regulations were drafted), the question is not difficult to answer.
Knowing the amounts of the assumed mortgages is crucial to determine the amount of any cash
payments due between the parties in order to equalize equity values. In this ideal world, the
parties are simply trading equity (or “redemption values”), and no question arises as to whether
the assumed mortgages are part of the consideration. They obviously are. But in a world of
deferred exchanges involving intermediaries and due-on-transfer provisions, the answer is not so
clear. Is a mortgage encumbering the relinquished property “part of the exchange” if it is simply
paid off at closing? Northshore Bus. Co. v. Commissioner; 143 F.2d 114 (2d Cir. 1944); Barker
v. Commissioner, 74 TC 555 (1980), FSA 19991069 and PLRs 9853028 and 9853029 all say
“yes.” There is no authority under Section 1031 to say “no.” Compare Maddox v. Commissioner,
69 T.C. 854 (1978) (a loan pay-off is not a liability assumed or "taken subject to" for purposes of
the installment sale rules of Section 453). Any potential application of Maddox to Section 1031
should also be superseded by the revisions to Section 1031(d), which now provide that for
purposes of Section 1031 a liability will be considered assumed if it falls within the definition of
Does this holding extend to non-mortgage liabilities that are paid off at closing? TAM 83280211
indicates that non-mortgage liabilities should be treated the same as mortgage liabilities, so the
answer should be “yes.” Does this mean that the taxpayer’s credit cards, medical bills, car loans
or other unsecured personal liabilities may also be paid off at closing and treated as part of the
exchange? If not, why can one kind of liability be netted and not the other? What if the taxpayer
had refinanced the property years ago with a mortgage to pay off personal liabilities? Again, why
allow one kind of liability to be offset and not the other?
The “part of the exchange” requirement may have no teeth once it is granted that loan payoffs
are treated the same as assumed liabilities. A loan payoff is “part of the consideration” received
by the taxpayer only in the sense that the gross sales proceeds are the consideration for the
transfer of the property and the loan is paid off out of this cash consideration. But this furnishes
no basis to distinguish between personal credit card debt and the original purchase money
mortgage. Both are liabilities, both are paid off out of the consideration paid by the buyer, and
both are “part of the exchange” in this sense.
Notwithstanding the above, a literal application of the liability netting rule may be limited by
case law and judicial doctrines. The Service or a court is likely to look askance at a taxpayer who
charges his personal credit card debt, medical bills, car loans, etc. to the relinquished property
escrow and then attempts to offset these liabilities with debt incurred to acquire the replacement
property. In Barker, the court held that “boot-netting is permissible in a case where
contemporaneously with the exchange of properties and where clearly required by the
contractual arrangement between the parties, cash is advanced by the transferee... to enable the
transferor... to pay off a mortgage on the property....” 74 T.C. at 572 (Emphasis added.) The
court distinguished this case from Coleman v. Commissioner, 180 F.2d 758 (8th Cir. 1950), and
the examples under Reg. Section 1.1031(d)-2 where cash was paid to the taxpayer to compensate
him for a difference in net values (fair market value less mortgage) in the properties exchanged.
The court also emphasized that the taxpayer’s net investment in the replacement property was no
less than his investment in the old property and that at no time did the taxpayer obtain dominion
and control over cash to do with as he pleased. The taxpayer was contractually obligated to use
the cash to pay off the mortgage, had no option to put the cash to other use and simply acted as a
conduit for the funds.
Paying off personal credit card debt is unlikely to meet the limitations imposed by Barker. First,
generally speaking, it makes no sense for the contractual arrangements between the parties to
require that the funds be used to pay off the taxpayer’s credit cards. The transferee could care
less whether or not the taxpayer paid off his credit card debt but cares a great deal whether or not
an encumbrance to title is paid off. One can imagine exceptional cases where the transferee
might care about the taxpayer’s credit card debt, such as where the transferee is also a lender to
the taxpayer, but such cases are very rare. Second, the taxpayer’s credit card debt is unlikely to
be taken into account as part of the taxpayer’s “net investment” in the property. The court in
Barker indicated that the taxpayer’s investment is his equity (fair market value of the property
less mortgages). Paying off personal credit card debt is likely to be perceived as diminishing (not
continuing) the taxpayer’s investment in like-kind property. This is not to say that non-mortgage
liabilities related to the taxpayer’s investment in the property should not be taken into account.
For example, what if the taxpayer incurred and paid off credit card debt to make improvements
to the property? The court in Barker simply does not address that issue. Third, the taxpayer’s
unilateral decision to pay off his credit card debt is likely to be viewed as the use of unfettered
cash as the taxpayer pleases. It is unlikely, for example, that his credit card agreements require
him to pay off the debt whenever he sells a piece of property. If the taxpayer submits a unilateral
demand to pay the debt off, he is exercising dominion and control over the proceeds and not
acting as a “mere conduit.”
The case of personal unsecured debt should be distinguished from cases where the taxpayer is
obligated to pay a contractor for improvements to the property at closing. In the latter case, the
taxpayer would be in breach of contract if the obligation was not paid at closing, even thought
the liability may be unsecured. Further, incurring and paying off a liability to improve the
property does not reduce the taxpayer’s “investment” in the property within the meaning of
Barker. The fair market value of the property and the liabilities would both presumably increase
as a result of the improvements. Contractual arrangements with the transferee may also require
the payment of such an obligation (e.g., to avoid the recording of a mechanic’s lien against the
Can a serious argument be made in favor of netting personal unsecured debt (or an unrelated line
of credit) in light of Barker? Maybe. The taxpayer may argue that his case is, in substance, no
different that a taxpayer who mortgages the property before the exchange and uses the loan
proceeds to pay off his credit cards. Assuming that the mortgage may be offset under Barker,
why can’t the taxpayer do directly what he can do indirectly by mortgaging the property? But
putting aside (or assuming away) the issue of any borrowing in anticipation of the exchange, we
still are left with a problem. The taxpayer did not in fact mortgage his property and reduce his
“investment” in the property before the exchange. “What might have been” did not in fact
happen and is likely to be ignored. See Behrens v. Commissioner, T.C. Memo 1985-195.
Aggressive taxpayers who insist upon netting personal unsecured debt might attempt to satisfy
the Barker requirements through various means. It could be part of the contractual arrangement
between the parties that such debt be paid off (although such provisions may be seen as self-
serving and meaningless). The taxpayer may attempt to establish a connection between the debt
and his investment in the property. For example, the funds may have been used to restore other
funds that were used to pay property expenses or make improvements. The taxpayer may also
receive requests from his lenders (either the unsecured lender or the lender for the replacement
property) to pay off the debt upon closing. Even then the best advice is to avoid netting personal
unsecured debt or other unrelated debt in an exchange. The taxpayer is better off mortgaging the
property and paying off the debt, even if the borrowing is in anticipation of the exchange. Most
advisors would rather take their chances with that issue than with open and direct netting of
personal unsecured debt.
Even if the taxpayer satisfies the Barker requirements for boot-netting in a liability payoff
situation, a liability may be disregarded based on the substance over form or step transaction
doctrines. See Long v. Commissioner,77 T.C. 1045 (1981) (the court disregarded an amendment
to the partnership agreement six weeks before the exchange to alter a partner’s share of
partnership liabilities, taking into all of the facts of the case, including a borrowing of money two
days before the exchange to increase the partner’s share of liabilities); Behrens v. Commissioner,
T.C. Memo 1985-195 (excess purchase money loan for replacement property caused the taxpayer
to received cash boot in reduction of his exchange equity; excess loan proceeds were not part of
an “independent borrowing”); PLR 843015 (May 16, 1984) (borrowing immediately before the
exchange did not qualify under the liability netting rule because it was done solely to avoid the
receipt of boot).
In Long, the court applied the substance over form doctrine to disregard a reallocation of the
taxpayer’s share of liabilities within six weeks of a like-kind exchange. Citing familiar cases, the
court stated: “The form will not be permitted to control over the substance where the form was
chosen merely to alter the tax liabilities of the parties.” The court went on to determine that the
reallocation of liabilities under the amendment to the partnership agreement (1) did affect the tax
liabilities of the parties because of the Section 1031 exchange and (2) had no economic
substance aside from its tax effects. The court concluded: “[T]he debt was simply incurred too
close to the date of the actual exchange and the resulting amounts were too equal for us to
believe that the partners did not have an intent to alter the tax results of the exchange by this
borrowing. Considering the relationship of the two agreements of March 31, 1975, and the
borrowing of $400,000 by Venture Twenty-One on May 7, 1975, we are convinced that the
March 31, 1975, amendments were entered into solely to reduce the amount of boot received by
petitioners in the exchange, thus reducing their potential tax liabilities. For that reason, we
conclude that no effect should be given to the March 31, 1975, amendments to the agreements of
the partnerships and we will proceed on the assumption that for tax purposes they are to be
disregarded.” 77 T.C. at 1080.
The court did not disregard the $400,000 borrowing two days before the exchange by the second
partnership in which the taxpayer received an additional partnership interest (the taxpayer’s
replacement property). The taxpayer was credited with his pre-amendment 50% share of such
liability in determining the boot on the exchange (the excess of liabilities relieved over liabilities
assumed). The court only disregarded the partnership amendment which reallocated the liabilities
of both partnerships among the partners in an attempt to avoid the receipt of boot by the
It remains unclear whether a liability has economic substance if it is incurred in anticipation of
an exchange. See Fredericks v. Commissioner, T.C. Memo 1994-27 (refinancing of mortgage 25
days before transferring the relinquished property in a deferred exchange was respected). In
Fredericks, the taxpayer netted over $2 million in loan proceeds after paying off the old
mortgage. The court held that the funds were received from a lender as a result of refinancing
and not from the transferee as part of the exchange. The taxpayer had reasons for refinancing the
mortgage that were unrelated to the exchange since the old loan was coming due. But these
reasons did not explain why the debt was substantially increased and why the taxpayer pulled out
over $2 million in loan proceeds shortly before the exchange. A proposed regulation would have
excluded liabilities incurred “in anticipation of an exchange” from the netting rule and would
have treated such liabilities as cash boot. The proposed rule was dropped when final regulations
were issued because it would have created “substantial uncertainties.” See T.D. 8343 Preamble
(April 11, 1991).
In Garcia v. Commisioner, 80 T.C. 491 (1983), acq. 1984-2 C.B. 1, the transferee (not the
taxpayer) increased its mortgage on the replacement property shortly before the exchange. The
Service argued that the increase to the transferee’s mortgage was an “artificial attempt to
reallocate liabilities for the purpose of tax avoidance” citing Long. But the Service apparently
did not think about this issue. If the transferee’s mortgage had not been increased, the taxpayer
would simply have had to add cash or incur other debt to pay the balance of the purchase price.
See TAM 8003004 (taxpayer’s new loan to acquire replacement property offsets liabilities
relieved whether it is characterized as a cash payment or as an assumption of a liability). The
court held that, insofar as the taxpayer was concerned, there was an assumption of a debt that had
independent economic substance. Since the taxpayer had assumed responsibility to pay the
mortgage on the replacement property until it was paid off, no one could have reasonably
concluded otherwise. The fact that the debt was created by the transferee at the taxpayer’s
request was beside the point.
In PLR 8434015, the Service ruled that debt added by the taxpayer immediately before an
exchange did not qualify because the loan was made solely to avoid the receipt of boot. Compare
PLR 8248039 (refinancing to “balance liabilities” in the exchange did not result in boot). In PLR
843015, the Service stated that taxpayers should not be allowed to take advantage of a “literal
reading of the netting rule” if the substance of the transaction is tantamount to money received.
In Behrens, supra, an excess purchase-money loan was incurred for replacement property during
the exchange. The loan resulted in reduced equity in the exchanged trucks (the old trucks had
equity of $38,000 and the new trucks had equity of $16,000 when received in the exchange). The
taxpayer received cash in the amount of the reduction in equity ($22,000). The court held that the
cash received caused part of the gain to be recognized under Section 1031(b) ($22,000 of the
total gain of $29,000 had to be recognized). The taxpayer in Behrens claimed that he should not
be taxed on the transaction as it was actually cast. The taxpayer observed that he could have
achieved the same economic result without being taxed by borrowing before or after the
exchange. However, the court ruled that tax consequences are governed by what was actually
done rather than what might have been. The court stated: “If petitioner had borrowed the money
[$22,080.37] from a third-party lender, he would have received the cash in a nontaxable event:
the borrowing of money. But petitioner actually obtained the $22,080.37 through an exchange of
property.... Thus, the fact that petitioner could have reduced his net equity in his truck tractors
before or after the trade-in through a nontaxable loan... neither conflicts with nor derogates our
holding. It simply did not happen. Petitioner’s liquidation of a part of his net equity in his truck
tractors through the exchange places the transaction under §1031(b) and petitioner’s gain must
be recognized to the extent of the $22,080.37.” 49 T.C.M.. at 1291.
Behrens may support the ability to borrow money in a separate transaction before or after an
exchange. The court noted that the taxpayer could have applied all of his equity to the down
payment for the new truck tractors and reduced his purchase money financing accordingly. If the
taxpayer had borrowed the $22,000 before or after the exchange from a third party, the court
implied that he could have avoided a taxable result. The court cited Commissioner v. Tufts, 461
U.S. 300, 307 (1983) for the general rule that loan proceeds are not subject to income tax. See
also Michaels v. Commissioner, 87 T.C. 1412 (1986), where the court stated: “Generally, funds a
taxpayer borrows are not includable in his gross income, even though they increase his assets,
because the taxpayer has a corresponding liability to repay the loan.” However, this application
of Behrens is limited to some extent by the court’s footnote (n.13 at 1291) referring to the “step
transaction doctrine” and by the fact that the loan was assumed to be made by a third party. In
the footnote, the court stated that its discussion of “what might have been” (a borrowing from a
third party) assumed that “the loan and exchange transaction would be respected for tax purposes
and not collapsed under the step transaction doctrine.”
The potential collapsing of loan and exchange transactions under the step transaction doctrine
could apply to a liability incurred before, during or after an exchange. Notwithstanding this risk,
the doctrine has never been successfully applied by the Service to create boot under Section
1031(b). Fredericks is the only case to consider a pre-exchange refinancing (as opposed to the
reallocation of partnership liabilities that occurred in Long). The Service lost. The rationale set
forth in PLR 8434015 was effectively repudiated by the court.
The treatment of certain liabilities and other items under Section 1031 remains unclear. If the
item is a liability, the standards for determining whether it is counted under the netting rule vary.
One approach is to apply the principles of Section 357(d) and determine whether the taxpayer
has been relieved of or assumed a liability. Another approach is to apply the requirements
gleaned from Barker: (1) payment of a liability pursuant to a contractual arrangement; (2)
continuity of the taxpayer’s net investment; and (3) no dominion and control over unfettered
cash. Another approach is to apply the netting rule literally, tempered only by the judicial
doctrines of substance over form and step transactions. These approaches overlap and are not
mutually exclusive. Common sense and economic reality may, at times, conflict with a literal
application of the netting rule. In some cases, such as the payoff of unrelated debt, advisors
cannot predict with any comfort which approach will prevail.
Pay Down/Readvance Transactions and Other Types of Refinancing.
In general, a post-exchange refinancing should be of less concern from a tax perspective than a
pre-exchange refinancing because the taxpayer will remain responsible for repaying a post-
exchange liability whereas the taxpayer will be relieved from the liability for a pre-exchange
refinancing upon transfer of the relinquished property. A fundamental reason why borrowing
money does not create income is that the money has to be repaid and therefore does not
constitute a net increase in wealth. However, this issue is greatly complicated by pay-down, pay-
up transactions. Are such transactions a true post-exchange refinancing or has the taxpayer in
substance reduced his equity and received cash boot in the exchange. See Behrens, supra.
Pay-down, pay-up transactions typically involve net-leased replacement property where the debt
on the property is fixed and cannot be paid down or can only be paid down at a very high cost.
To avoid the receipt of cash boot, the exchanger wants to use all of the equity from the
relinquished property as part of the purchase price for the replacement property and not assume
or take subject to excess debt that encumbers the replacement property. Complicated agreements
may be entered with the cooperation of the lender pursuant to which the debt is temporarily paid
down and then funds are advanced to the taxpayer by the lender. The end result is that the debt
on the replacement property returns to what it was before the taxpayer’s receipt of the
replacement property. It is unclear whether such transactions (also known as “pay down,
readvance” structures) will be respected as a valid post-exchange refinancing or treated as the
receipt of cash boot by the taxpayer in an amount equal to the funds advanced by the lender. The
answer may depend on many factors: (1) whether there is a clear break between the acquisition
and refinancing, even if for only a "nanosecond"; (2) whether the taxpayer is legally required or
economically compelled (e.g., by prepayment penalties or other costs) to take the readavance
from the lender; (3) the tracing of the funds, and whether the relinquished property sales
proceeds actually pay down the debt to the lender or are simply impounded or otherwise held by
a third party and then released to the taxpayer; (4) if the funds are held pursuant to an impound
or defeasance arrangement, who is considered to own the funds; and (5) whether “fresh funds”
can be used to make the advance to the taxpayer.
With respect to these transactions, the IRS may argue that the receipt of financing proceeds and
the disposition of relinquished property are so closely linked that the two should be integrated, or
treated as steps in a single transaction. The step transaction doctrine was asserted by the Service
and rejected by the court in Fredricks, supra. However, the court in Behrens, supra, warned of
the potential application of this doctrine to financing in connection with an exchange. Courts
have applied the step transaction doctrine to collapse the individual steps of a complex
transaction into a single integrated transaction for tax purposes by applying three tests: (1) end
result, (2) interdependence, and (3) binding commitment. See Kornfeld v. Commissioner, 137
F.3d 1231 (10th Cir. 1998); Kuper v. Commissioner, 533 F.2d 152, 156 (5th Cir. 1976);
McDonald's Restaurants of Illinois v. Commissioner. 688 F.2d 520 (7th Cir. 1982).
If the exchanger is not under a binding commitment from the lender to refinance the replacement
property, a court might not conclude that the ultimate refinancing of the replacement property
must be collapsed into the original transfer of the replacement property. This assume that the
court applies the binding commitment test for step transaction analysis. But see True v. U.S., 190
F.3d 1179 (10th Cir. 1999) (the court applied the end result and the interdependence tests in
concluding that a series of transactions between related parties was not subject to the rules of
Section 1031). Even if the exchanger is not under a binding commitment to take the readavance,
the question remains who owns and is entitled to receive the funds. In both the pay-down,
readvance structures and the cash-out purchase loan, the relinquished property funds deposited to
a replacement property purchase closing may be clearly traced to the so-called “readavance.” If
fresh funds are not used to make the loan advance, this presents the greatest risk that the
exchanger will be deemed to have reduced its equity and received cash boot in the exchange. See
Mortgage Netting Rules.
While the realized gain represents the potential gain, the recognized gain is the actual taxable
gain that must be included in income. Realized gain is “recognized” or taxed only to the extent of
the net “boot” received by the taxpayer. See Section 1031(b). In general, the taxpayer is only
taxed on the net boot received. The taxpayer can also give boot in an exchange, and this boot
given will in some instances offset boot received by the taxpayer. Boot given or paid by the
taxpayer includes paying additional cash for the replacement property, assuming a mortgage on
the replacement property or giving the seller of the replacement property a note. In determining
the amount of net boot received by the taxpayer, certain offsets are allowed and others are not.
Rule 1. Liabilities incurred by the taxpayer in the exchange offset liability relief of the taxpayer.
See Reg. Section 1.1031(b)-1(c), 1.1031(d)-2, Example (2); Rev. Rul 79-44, 1979-1 CB 265.
This rule applies in a deferred exchange even though the liability relief occurs days or months
before the new liability is incurred. See Reg. Section 1.1031(k)-1(j)(3), Example 5.
Example. Taxpayer transfers relinquished property with value of $100,000 and mortgage of
$30,000 in a deferred exchange. Within 180 days, taxpayer acquires replacement property with a
value of $90,000 and mortgage of $20,000. The mortgage assumed by the taxpayer of $20,000
partially offsets the $30,000 in mortgage relief from the relinquished property, resulting in
$10,000 of net boot received and gain recognized by the taxpayer.
Non-mortgage liabilities may be netted against mortgages under IRC Section 1031. Reg.
Sections 1.1031(b)-1(c) and 1.1031(j)-1(b)(2)(ii); PLR 8328011. For purposes of Section 1031,
“liabilities” are certain sums due at a fixed or determinable date of maturity and include accrued
interest assumed by the transferee. Liabilities assumed by the transferee do not, however, include
security deposits or prepaid rents depending on the provisions of state law. See Ltr. Rul
8328011; Rev. Rul 75-363, 1975-2 CB 463. The determination of the amount of the liability
assumed is made under Section 357(d). See Section 1031(d).
Rule 2. Cash paid by the taxpayer in the exchange offsets liability relief of the taxpayer. See Reg
Section 1.1031(d)-2; Rev. Rul 79-44, 1979-1 CB 265.
Example. If the relinquished property has a fair market value of $100,000, a mortgage of
$50,000, and equity of $50,000, the taxpayer may acquire a replacement property with a fair
market value of $100,000, mortgage of $20,000 (vs. the $50,000 mortgage relief from the
relinquished property), exchange equity of $50,000, plus additional cash from the taxpayer of
$30,000 with no recognition of gain.
Rule 3. Cash paid by the taxpayer in some circumstances offsets cash received by the taxpayer.
See Reg Section 1.1031(d)-2; Rev. Rul 72-456, 1972-2 CB 468. Revenue Ruling 72-456, Rev.
Rul 72-456, 1972-2 CB 468, holds that money paid out in connection with an exchange offsets
money received in computing gain realized and recognized. In the ruling, the taxpayer is allowed
to offset cash received by the payment of brokerage commissions. In a deferred exchange,
however, the Regulations take the position that cash received by the taxpayer during the
exchange may not be offset by cash subsequently paid by the taxpayer for the acquisition of the
replacement property. Reg. Section 1.1031(k)-1(j)(3). Example 2.
Example. Taxpayer exchanges real property with a value of $100,000 in a deferred exchange and
receives $10,000 cash at the time of the closing of the relinquished property. The replacement
property is acquired within 180 days for a value of $100,000, including the remaining $90,000 of
exchange equity from the disposition of the relinquished property and $10,000 in additional cash
paid by the taxpayer. The $10,000 subsequently paid by the taxpayer does not offset the $10,000
received by the taxpayer and the taxpayer recognizes $10,000 of gain.
Presumably, this example is limited in its application to its facts. Other situations frequently
occur in which the taxpayer may want to rely on Revenue Ruling 72-456 for the position that
cash boot paid by the taxpayer offsets cash received by the taxpayer. For example, if the taxpayer
pays the earnest money deposit for the acquisition of the replacement property from the
taxpayer’s separate funds, any cash boot received by the taxpayer from the closing of the
replacement property should be offset by the earlier earnest money deposit payment. The
taxpayer may also offset cash boot received in the form of the payment of non-exchange
transactional costs, such as loan fees for the replacement property, with cash paid by the taxpayer
in the form of additional payments for the replacement property.
Alternatively, the taxpayer may receive cash boot prior to the closing of the relinquished
property in the form of an option payment or non-refundable earnest money payment. The
taxpayer may arguably offset the cash boot received by cash boot given if the taxpayer deposits
the payment in escrow prior to closing of the relinquished property, but this remains unclear. See
PLR 7952086. If the taxpayer retains the option payment or earnest money, it will constitute
taxable “boot” at the time of the exchange, See PLR 9413024; Section 1031(b). In addition, the
taxpayer may want to offset the receipt of an installment note from the buyer of the relinquished
property with cash paid by the taxpayer.
Example. Taxpayer receives a note from the buyer of the relinquished property in the amount of
$50,000 and at the same time uses $50,000 of the taxpayer’s own funds as additional equity for
the replacement property. This situation has not been addressed in either the regulations or in the
case law to date. Cautious taxpayers will structure their transactions to avoid the need to offset a
buyer’s note with cash boot paid. Example 2 of Reg. Section 1.1031(k)-1(j)(3) indicates that the
above offset would not be allowed if the taxpayer receives the note upon the closing of the
relinquished property and subsequently pays additional cash for the replacement property.
However, if the taxpayer adds the cash to the escrow for the relinquished property or otherwise
separately pays for the note before or at the time the note is received, the taxpayer arguably has
not received the note out of the exchange equity, and the note should not be taxable boot to the
Rule 4. Liabilities incurred by the taxpayer do not offset cash received by the taxpayer. See Reg.
Section 1.1031(d)-2, Example (2)(c); Rev. Rul 79-44, 1979-1 CB 265; Coleman v.
Commissioner, 180 F.2d 758 (8th Cir. 1950). Thus, the taxpayer cannot take cash out of the
exchange at closing by incurring a liability on the replacement property greater than the liability
on the relinquished property.
Example. Taxpayer exchanges property with a fair market value of $100,000, a mortgage of
$50,000, and equity of $50,000 for a property with a fair market value of $100,000, mortgage of
$80,000, and equity of $20,000. The taxpayer receives the balance of the exchange proceeds of
$30,000 in cash. Taxpayer cannot offset the cash received of $30,000 by liability increase of
$30,000. The taxpayer will be taxed on the receipt of the $30,000 cash.
A taxpayer may overestimate the size of the liability necessary to acquire the replacement
property with the result that excess exchange proceeds from the transfer of the relinquished
property will be distributed to the taxpayer and taxed as boot. See Behrens v. Commissioner,
T.C. Memo 1985-195. The taxpayer may eliminate the boot by reducing the amount of the note
representing the loan or the seller financing for the replacement property by the excess exchange
proceeds at or before closing of the replacement property so that the taxpayer never receives any
cash but he cannot pay down the debt after the closing and avoid boot.
This can be a problem in a deferred exchange when the taxpayer intends to acquire two or more
replacement properties, acquires the first replacement property with financing and leaves
remaining exchange proceeds with the intermediary to purchase a second replacement property.
The second replacement property is not acquired and the taxpayer wants to use the remaining
exchange proceeds to pay down the liability on the first replacement property. This pay down
will be taxable boot to the taxpayer even though it is made within the 180-day exchange period
because the taxpayer has already taken title to the first replacement property and the intermediary
is simply paying down a liability on property already owned by the taxpayer.
The IRS has stated that purchase money financing obtained by the taxpayer for the replacement
property is either cash boot or mortgage boot, and will offset liability relief from the relinquished
property. See TAM 8003004. New financing should be treated as mortgage boot paid by the
taxpayer, which can offset mortgage boot received by the taxpayer on the relinquished property,
but not cash boot received by the taxpayer in the exchange, See PLR 9853028. Under the boot
offsetting rules, if new financing is instead characterized as cash boot paid, then the taxpayer
could potentially receive nontaxable cash boot in an exchange by offsetting cash received with a
larger new acquisition loan for the replacement property. One case has held, however, that it is
immaterial whether the debt is existing debt or newly created debt. The new loan should be
treated as mortgage boot given by the taxpayer rather than cash boot given. See Behrens, supra.
As a result, the taxpayer cannot offset cash received in the exchange with seller financing and
presumably any other form of new loan on the replacement property. The Tax Court viewed the
receipt of cash at closing as a liquidation of the taxpayer’s equity and not as a separate loan from
the seller of the replacement property.
As noted above, the treatment of mortgages on the relinquished property is clearer. The taxpayer
is treated as receiving mortgage boot rather than cash boot even if the buyer of the relinquished
property pays cash for the property or obtains a new loan and the existing mortgage is paid off at
closing rather than assumed by the buyer. Even though the taxpayer is technically receiving cash
and then paying off the mortgage at closing, the taxpayer is not considered to have received cash
boot because the taxpayer is contractually obligated to pay off the mortgage and does not have
control of the cash. See Northshore Bus. Co. v. Commissioner, 143 F.2d 114 (2d Cir. 1944);
Barker v. Commissioner, 74 TC 555 (1980), FSA 19991069. The taxpayer is merely a conduit
for payment of the liability by the buyer. If the taxpayer were considered to have received cash
boot, the taxpayer could not offset the liabilities on the relinquished property with the liabilities
incurred in acquiring the replacement property, and this would have very adverse effects on most
exchanges. The IRS has ruled, however, that indebtedness on the relinquished property that is
paid off by the buyer may be netted against a new liability incurred by the taxpayer to acquire the
replacement property. See PLR 9853028.
There is no express requirement in the regulations that unsecured liabilities relate to the
relinquished property. However, the Barker case seems to require that the taxpayer be
contractually obligated to pay off any liabilities that are paid off at the closing or the payment
will be treated as taxable cash boot to the taxpayer. Otherwise, the taxpayer could require the
intermediary to use exchange proceeds to pay off unrelated, unsecured liabilities of the taxpayer,
such as credit card debt, by requiring the intermediary to assume the liabilities under the
exchange agreement and pay them off at closing of the relinquished property. Taxpayers should
be careful about what liabilities are paid with the exchange proceeds. If at all possible, the
liabilities should be secured by the relinquished property so the taxpayer is contractually
obligated to pay them off to clear title. Further, the taxpayer should be able to trace any
unsecured liabilities directly to the relinquished property and to establish that these unsecured
liabilities were required be paid off as part of the closing. The purchase and sale agreement or the
exchange agreement for the relinquished property may be amended to specify the amount and
identity of any unsecured liabilities and to require that they be paid off at closing.
A taxpayer does not receive mortgage boot if the relinquished property is transferred in the
exchange subject to an existing debt but the taxpayer remains contractually liable to make
payments of the debt and indemnifies the buyer from any loss due to the debt. There is not net
financial advantage to the taxpayer and thus no mortgage relief. See PLR 8346014. As noted
above, if the taxpayer receives a note from the buyer of the relinquished property, the note is
treated as cash boot which may not be offset with mortgage boot given by the taxpayer. See PLR
8434015 (installment note received by taxpayer during exchange was treated as cash boot
received that could not be offset by mortgages assumed).
In PLR 200019014, all of the taxpayers (six partnerships which will own the replacement
properties as tenants in common) were required to be jointly and severally liable for the
mortgages on the replacement properties. The partnerships entered into a “debt-sharing
agreement” which will (i) allocated the risk of loss among the partnerships so as to “ensure that
the amount of each partnership’s debt is not reduced by the exchange,” (ii) obligated each of the
partnerships to make sure its proportional share of payments on the loans is secured by the
replacement properties, and (iii) obligated each of the partnerships to indemnify the other
partnerships against any failure to make such payments. The Service ruled that the joint and
several obligation of the partnerships to pay the entire amount of the mortgages “will not result
in a reduction in any partner’s share of partnership debt.” This ruling may support the special
allocation of debt by agreement among co-owners, even though a loan provides for joint and
several liability. Further, the debt-sharing agreement did not cause the co-owners to be treated as
partners in a partnership, even though the agreement specially allocated the loan liabilities to
avoid the receipt of boot by each co-owner. This is the sensible result. Nothing in the Section
761 regulations should preclude co-owners from having an agreement concerning their
proportionate shares of a blanket liability. See also PLR 7935126 (June 4, 1979) (allocation of
liabilities based on who actually bears the liability and risk of loss, not necessarily to the owner
of the property that secures the liability).
In Rev. Rul. 2003-56, 2003-23 I.R.B. 985, the IRS concluded that liabilities are netted for
purposes of Section 1031 and Section 752 when a partnership enters into a deferred like-kind
exchange that straddles tax years. Thus, when a partnership transfers relinquished property
subject to liabilities in one year and receives replacement property subject to liabilities in the
next year, the partnership liabilities are netted both for purposes of Section 1031 and Section
752. Any net decrease in a partner’s share of partnership liabilities is taken into account under
Section 752(b) in the first year of the partnership, and any net increase in a partner’s share of
partnership liabilities is taken into account under Section 752(a) in the second year of the
Under Rev. Rul. 2003-56, only the net decrease in liabilities (after taking into account the
replacement liability in the second year) is treated as a deemed distribution of money to the
partners. Accordingly, any net decrease in a partner’s share of liabilities is taken into account in
the first taxable year of the partnership since it is attributable to the transfer of the relinquished
property subject to the relinquished liability in that year. Any deemed distribution of money to
the partners under Section 752(b) in the first taxable year of the partnership is treated as an
advance or drawing of money to the extent of each partner’s distributive share of partnership
income for that year. For this purpose, any gain recognized by the partnership under Section
1031(b) is included in each partner’s distributive share of partnership income for the first taxable
year of the partnership and this increases the partner’s basis in his partnership interest. An
amount treated as an advance or drawing of money is taken into account by the partners at the
end of that year.
In addition, Rev. Rul. 2003-56 holds that if a partner’s share of the replacement liability exceeds
the partner’s share of the relinquished liability, only the net increase in liability is taken into
account for purposes of determining the increase in the partner’s share of partnership liabilities
under Section 752(a). The IRS concluded that the net increase is taken into account in the second
taxable year of the partnership since it is attributable to the receipt of the replacement property
subject to the replacement liability in that year.
Rules Relating to Pre- and Post-Exchange Refinancing.
In general, loan proceeds are not subject to income tax. See Commissioner v. Tufts, 461 U.S.
300, 307 (1983). Thus, taxpayers may borrow money before or after an exchange to receive tax-
free cash. The liability netting rule does not itself limit the kinds of liabilities that may be netted
or require any seasoning period for a liability. Compare Reg. §15A.453-1(b)(2)(iv) (defining
“qualifying indebtedness” in an installment sale). However, judicial doctrines may limit a
taxpayer’s ability to receive tax-free loan proceeds before or after an exchange.
Pre-Exchange Refinancing of Relinquished Property.
Existing authority indicates that where pre-exchange refinancing is completed as part of an
integrated transaction that includes the exchange, cash received by a taxpayer from a lender will
be treated as cash received on the disposition of the relinquished property. See Long v.
Commissioner, 77 T.C. 1045 (1981) (reallocation of partners’ liabilities within six (6) weeks
before exchange disregarded); Garcia v. Commissioner, 80 T.C. 491 (1983), acq. 1984-2 C.B. 1
(test is whether debt has “independent economic substance”); PLR 8434015 (May 16, 1984)
(loan proceeds received in anticipation of an exchange treated as cash boot because such a loan
does not have “independent economic significance”).
Assume that A transfers unencumbered Property 1 (worth $200X) in an exchange with B, who
will transfer encumbered Property 2 (worth $200X, encumbered by a $100X mortgage). As part
of the exchange but immediately prior to conveying Property 1, A obtains a new $100X loan
secured by Property 1. A and B then exchange and each takes subject to (or assumes) the loans
encumbering the properties. In effect A has "cashed out" in the amount of $100X, but if the rules
of Reg. Section 1.1031(b)-1(c) are strictly construed, A has recognized no gain since A took
Property 2 subject to debt which equaled the debt relief. See Fredericks v. Commissioner T.C.
Memo 1994-27; PLR 8248039 (increasing debt to balance the liabilities in the exchange was
permitted). Notwithstanding this literal application of the liability netting rule, the Service is
likely to assert that A has recognized gain of $100X because the cash received from the
refinancing should be viewed as part of the consideration given by B to acquire Property 1 from
This principle is sometimes referred to as borrowing "in anticipation of an exchange." The
Service attempted to include this concept in the Section 1031 regulations by proposing an
amendment to Reg. Section 1.1031(b)-1(c) and referring to this as a “clarification of existing
law.” Protests from practitioners and the public led the Service to conclude the proposed rule
"could create substantial uncertainty in the tax results of exchanges." The proposal was
withdrawn in the final regulations adopted in 1991. Although the proposed regulation was
withdrawn, the Service has not formally stated whether it still adheres to the proposition. This
was its position in Fredericks, supra. See also PLR 8434015.
Where a pre-exchange refinancing is clearly part of the exchange, the step transaction and
substance over form doctrines allow the Service to prevent taxpayers from using the liability
netting rules to avoid tax on the receipt of cash (i.e., the pre-exchange financing proceeds). See
Behrens v. Commissioner, T.C. Memo 1985-195 at n. 13. If the debt has independent economic
substance and “comes to rest” (i.e., becomes the taxpayer's liability for more than the time
needed to close subsequent parts of an exchange), then the usual non-realization treatment should
apply and the existing netting rules should apply to the debt. Thus, "true" refinanced debt will be
offset either by debt assumed or taken subject to or by cash paid by the taxpayer. This means that
refinancing must occur as a separate and independent transaction from the transfer of the
property. The timing of the refinancing may be a crucial fact. Does the refinancing occur before
(i) the decision to sell, (ii) the listing of the relinquished property, (iii) the negotiation of a letter
of intent or binding contract, (iv) the execution of the contract, (v) the expiration of the
contingency period, or (vi) shortly before closing?
Another factor, considered in the Fredericks case, is whether the refinancing occurs for reasons
independent of the exchange, such as pending maturity of debt. Refinancing should not be
conditioned on completion of a relinquished property transfer nor should it be part of the same
escrow or settlement process. If credit evaluation is involved, it should be the taxpayer's credit
not the buyer’s credit that is used to obtain the loan. PLR 200019014 also involved pre-exchange
refinancing. The taxpayers refinanced mortgages on the relinquished properties in July of Year 1
to take advantage of lower interest rates, and some of the proceeds of the refinancing were
distributed to the partners to purchase other properties. The taxpayers represented that they did
not contemplate the exchanges at the time of the refinancing and were first approached
concerning the exchange transactions in February of Year 2. The Service ruled that the proceeds
of the refinancing will not be considered cash boot in the exchange because “the refinancing in
Year 1 had an economic significance that is independent from the proposed exchange” (i.e.,
lower interest rates on the new loans and the use of the refinancing proceeds to purchase more
properties). The Service followed Garcia and Fredericks.
Post-Exchange Refinancing of Replacement Property.
There is virtually no authority addressing the issue of post-exchange refinancing. Some
commentators subscribe to the “one nanosecond” concept and argue that a post-exchange
refinancing that occurs one nanosecond after the exchange should not result in the receipt of cash
boot. In Behrens v. Commissioner, T.C. Memo 1985-195, the court rejected the taxpayer’s
attempt to cast the taxpayer’s facts as a post-exchange refinancing. The court in Behrens
indicated that there is a distinction between excess purchase-money financing for replacement
property and post-exchange refinancing. Excess purchase-money financing will cause the
taxpayer to receive cash (taxable boot) in the exchange since not all of the taxpayer’s equity is
reinvested in replacement property when the exchange closes.
Post-exchange refinancing should be of less concern from a tax perspective than pre-exchange
refinancing because the taxpayer will remain responsible for repaying a post-exchange liability
whereas the taxpayer will be relieved from the liability for a pre-exchange refinancing upon
transfer of the relinquished property. The case law has consistently held that borrowing money
does not create income because the money has to be repaid and thus does not constitute a net
increase in wealth. If an advisor is concerned, loan transactions can be structured to provide
separate financing for (a) acquisition of the replacement property and (b) post-closing financing,
including improvement costs and optional advances or disbursements to the exchanger. While
this should help, the IRS could still make a step-transaction attack but has never successfully
done so in this context.