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Handling Closing Prorations
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
Like-kind exchanges must be reported on IRS Form 8824. The amounts reported on
Form 8824 determine whether or not the exchange is taxable, the amount of gain
or other income that must be recognized and, ultimately, the amount of tax due.
In working from typical closing (or settlement) statements to a completed Form
8824, various closing (or settlement) costs must be taken into account. The term “closing
costs” means (i) transaction costs (or “exchange expenses”),
(ii) prorations, and (iii) other items that appear on a typical closing statement.
In addition to closing costs, a closing statement shows the sale and purchase
price or “exchange value” of the property (“FMV”) and
mortgage and other liabilities (“liabilities”). Little official guidance
is available on how to account for prorations and other closing costs in reporting
a like-kind exchange on Form 8824. This article is intended to provide a reasonable
approach
“Transaction costs” are amounts charged to the taxpayer (debits)
for selling expenses (commissions, legal fees, transfer tax, escrow fees, etc.),
acquisition expenses (title insurance, finder’s fees, escrow fees, termite
report, etc.) and other exchange expenses (intermediary fees, exchange escrow
fees, legal and tax fees, etc.). Transaction costs paid by the taxpayer that
relate to the disposition of the relinquished property, the acquisition of the
replacement property or the exchange itself are also known as “exchange
expenses.” Exchange expenses reduce the realized gain and recognized gain
of the taxpayer and increase the tax basis of the replacement property. See Rev.
Rul. 72-456, 1972-2 C.B. 468; Mercantile Trust Co. of Baltimore v. Commissioner,
32 B.T.A. 82 (1935); PLR 8328011.
“Exchange expenses” are not the same thing as “transactional
items” under the deferred exchange safe harbors. See Reg. Section 1.1031(k)-1(g)(7). “Transactional
items” may be paid without violating the limitations on the taxpayer’s
rights to receive money or other property. “Transactional items” include
exchange expenses and other items that are typically found on a closing statement
that are not “exchange expenses,” including prorations for rent,
mortgage interest, property taxes, utilities charges, association fees and insurance
premiums.
“Prorations” are debits and credits for accrued or prepaid income
or expenses based on the date of closing, such as rent, insurance, property taxes,
utilities, etc. These items do not reduce the amount realized or recognized and
are not added to the basis of the replacement property. While these items may
result in taxable boot, some of these items may be deductible as interest, taxes
or operating expenses. Accrued interest and property taxes may be considered
a liability assumed by the buyer of the relinquished property. If they are treated
as a liability, the boot received by the taxpayer for these items may be offset
by liabilities assumed by the taxpayer on the replacement property. See PLR 8328011.
Other transactional items that are debited to the taxpayer and paid with exchange
equity will be taxable boot, but items credited to the taxpayer will be treated
as cash paid by the taxpayer and can offset the taxable boot from the non-exchange
expenses debited to the taxpayer.
However, boot from non-exchange expenses in connection with the relinquished
property probably cannot be offset by credits in connection with the replacement
property in a deferred exchange. The deferred exchange regulations have an anti-abuse
rule under which cash received from relinquished property may not be offset by
cash subsequently paid for replacement property. See Reg. Section 1.1031(k)-1(j)(3),
Example 2. This example states: “On May 17, 1991, B transfers real property
X to C and identifies real property S as replacement property, and C transfers
$10,000 to B. On September 4, 1991, C purchases real property S for $100,000
and transfers real property S to B. On the same day, B transfers $10,000 to C.
The $10,000 received by B is ‘money or other property’ for purposes
of section 1031 and the regulations thereunder. Under section 1031(b), B recognizes
gain in the amount of $10,000. Under 1031(d), B’s basis in real property
S is $50,000 (i.e., B’s basis in real property X ($40,000), decreased in
the amount of money received ($10,000), increased in the amount of gain recognized
($10,000), and increased in the amount of the additional consideration paid by
B ($10,000) in the deferred exchange).” The example involves an actual
cash payment to the taxpayer. It is an anti-abuse rule since taxpayers could
otherwise receive all of the sales proceeds and then pay them back to buy the
replacement property if this kind of cash boot could be netted in a deferred
exchange. It is unclear whether the example applies to boot attributable to non-exchange
expenses but the IRS is very likely to take this position unless the expenses
qualify as “liabilities” that may be offset under the liability netting
rules.
Security deposits and prepaid rent are also non-exchange expenses.
It is unclear whether or not they may be treated as “liabilities” assumed
as part of the exchange. See PLR 8328011. The answer may depend on how
these items are treated under applicable state law (i.e., whether the
deposits are held in trust for the benefit of tenant, or whether they
are considered an asset and liability of the owner). If the taxpayer
pays the buyer of the relinquished property a sum equal to the security
deposits or prepaid rent, this payment should avoid any taxable boot
to the taxpayer. Alternatively, if the buyer of the relinquished property
receives a credit against the purchase price and the taxpayer receives
a corresponding debit for the security deposits or prepaid rent, then
the taxpayer now holds the amount representing the security deposits
or prepaid rent free and clear and, in effect, has liquidated some of
his or her equity in the relinquished property by retaining the amounts
formerly representing security deposits or prepaid rent. Thus, if the
security deposits or prepaid rent are not considered liabilities, the
taxpayer will be treated as receiving cash boot to the extent of these
debits.
With respect to the replacement property, a check from the seller to the taxpayer
for security deposits or prepaid rent should not be taxable boot. The security
deposits do not represent income to the taxpayer because the taxpayer must
hold the funds as security deposits. The prepaid rent will be treated as rental
income to the taxpayer and not as gain from the exchange. A credit to the taxpayer
for the security deposits or prepaid rent against the purchase price of the
replacement property may be cash boot paid by the taxpayer and may offset debits
for non-exchange expenses in connection with the replacement property, such
as loan fees. But if the taxpayer treated the security deposits or prepaid
rents as “liabilities” in connection with the relinquished property,
he may have to be consistent with his treatment of these items in connection
with the replacement property (assuming that the applicable state law is the
same). In that event, the items would be treated as liabilities incurred by
the taxpayer which do not offset cash received under the boot netting rules.
“Other items” include debits or credits for loan fees, security deposits,
binder rebates, and other cash amounts paid into or received from escrow, including
earnest-money deposits made by the taxpayer outside of exchange funds. Loan fees,
points, loan application fees, mortgage insurance, lender’s title insurance,
assumption fees, and other costs related to the acquisition of a loan for the
replacement property, such as a loan appraisal, are also non-exchange expenses
and do not reduce realized or recognized gain. These costs are treated as costs
of obtaining a loan rather than as part of the costs of acquiring the property
and will not increase the basis of the replacement property. See S&L Bldg.
Corp. v. Commissioner, 19 B.T.A. 788 (1930); Andover Realty Corp. v. Commissioner,
33 T.C. 671 (1960). The costs related to obtaining a loan are amortized over
the life of the loan rather than the property purchased with the loan. See Rev.
Rul. 70-360, 1970-2 C.B. 103; Section 461(g)(1). If the loan costs are added
to the principal balance of the acquisition loan, they will reduce the equity
in the replacement property and may cause taxable boot to the taxpayer. Similarly,
if these costs are debited on the closing statement for the replacement property,
they may cause taxable boot to the taxpayer to the extent that exchange funds
are used to pay for the costs.
Reserves required by the lender are also non-exchange expenses, but may be
deducted by the taxpayer when paid by the lender on the taxpayer’s behalf
if the reserves are used for deductible items such as taxes or insurance. Reserves
for improvements after closing may not be deductible when used, but instead
are added to the depreciable basis of the replacement property. If exchange
proceeds or loan proceeds are used to pay reserves, this may cause taxable
boot to the taxpayer, unless the amount set aside for reserves is offset by
additional cash paid by the taxpayer towards the acquisition of the replacement
property. It may also be possible to treat an amount set aside for a reserve
as a contingent liability at the time of the exchange that should be ignored
for purposes of the Section 1031 computations.
If the taxpayer desires to avoid recognition of all gain on the exchange, the
taxpayer may want to add cash to the escrow for the disposition of the relinquished
property to the extent of the amounts debited on the closing statement fee
for non-exchange expenses. Similarly, any additional funds paid by the taxpayer
in excess of the exchange proceeds towards the acquisition of the replacement
property will be treated as cash boot paid by the taxpayer. The additional
funds will reduce the taxable boot caused by loan costs and any other non-exchange
expenses in connection with the replacement property.
The closing statements for two properties involved in a like-kind exchange
are summarized as follows. The schedule below shows the FMV, liabilities, transaction
costs and the total debits or credits for prorations or other items that are
not exchange expenses for each property.
Relinquished Property Replacement Property
Debits Credits Debits Credits
Fair market Value 2,000,000 3,000,000
Mortgage debt 1,200,000 2,380,000
Transaction costs 150,000 40,000
Prorations 40,000 20,000
Other items 20,000 50,000
Net proceeds 590,000 590,000
Totals $2,000,000 $2,000,000 $3,040,000 $3,040,000
Both Properties
Total debits $5,040,000
Total credits $5,040,000
Total transaction costs $190,000
In the above example, the taxpayer used exchange equity to pay $190,000 in
transaction costs. To the extent that the equity is used to pay transaction
costs, a "wash" occurs under the boot netting rules, and the taxpayer
has not received or paid any cash on a net basis. Accordingly, the taxpayer
does not realize or recognize any taxable gain, and does not receive any net
increase to the basis of the new property to the extent that exchange equity
is used to pay transaction costs. Basis is increased only by the amount of
out-of-pocket transaction costs. The treatment of exchange expenses and transaction
costs is discussed in a separate article. See the link on the main menu.
The question is whether prorations and other items that are not exchange expenses
cause the taxpayer to recognize gain in this example. The answer depends on
whether the transaction is a simultaneous or deferred exchange. In the above
example, total other credits of $70,000 for prorations and other items exceed
total other debits of $60,000. On a net basis, $10,000 in cash was added by
the taxpayer to the exchange. In a simultaneous exchange, the taxpayer would
offset the cash received from the prorations and other debits on the relinquished
property ($60,000) by the cash paid for prorations and other credits on the
replacement property ($70,000). See Rev. Rul. 72-456, 1972-2 C.B. 468 (cash
paid out in exchange offsets cash received in determining net boot received).
Thus, if the transaction is a simultaneous exchange, the taxpayer would not
receive any cash boot on a net basis and would not recognize any gain.
However, as noted above, a special anti-abuse rule applies to deferred
exchanges. Under Example 2 of Reg. Section 1.1031(k)-1(j)(3), cash received
from the relinquished property may not be offset by cash subsequently
paid for the replacement property. This rule may apply to cash deemed
to be received for prorations and other items on the closing of the relinquished
property. Thus, if the transaction is a deferred exchange and if the
prorations and other items are treated as cash boot rather than liabilities,
the total other credits of $70,000 subsequently paid for the replacement
property may not be able to offset the $60,000 in debits for prorations
and other items previously received for the relinquished property. In
that event, the taxpayer would have $60,000 in taxable boot and recognize
gain of $60,000 if the transaction is a deferred exchange. This analysis
assumes that part of the taxpayer’s exchange equity from the relinquished
property ($60,000) is applied to prorations and other debits that do
not qualify as exchange expenses or as “liabilities.” (Liabilities
are subject to special liability netting rules which are discussed in
a separate article. See the link on the main menu.). Accordingly, this
amount is likely to be treated as cash received by the taxpayer upon
the closing of the relinquished property just as if the taxpayer received
a check for $60,000.
The taxpayer must recognize gain if the taxpayer actually receives a check
at closing (an "other item") to compensate him for the difference
in equity values less transaction costs. Similarly, if exchange equity is used
for prorations and other debit items, the taxpayer also receives a benefit
in the form of cash previously received for prepaid rent or cash that he now
does not have to pay for operating expenses. If equity is used to pay for these
items, the economic benefit to the taxpayer is the same as the taxpayer receiving
a check at closing. For example, assume that the taxpayer received all of the
current month's rent from the property ($15,000), but the buyer is entitled
to two-thirds of the rent ($10,000) based on the closing date. The taxpayer
keeps the extra $10,000 in rent received, and his equity is charged with $10,000
to compensate the buyer. The taxpayer realizes a benefit equivalent to receiving
a $10,000 check at closing. In this example, the taxpayer will report rental
income received of $5,000 (not $15,000) and the buyer will report rental income
of $10,000. However, the taxpayer may recognize gain of $10,000 as a result
of the charge to equity for prepaid rent. If the taxpayer may keep the extra
$10,000 in prepaid rent without any tax consequence, the taxpayer gets an unwarranted
windfall. (However, as noted above, it is possible that prepaid rent may be
treated as a “liability” assumed by the other party and not as
cash boot.) Thus, to the extent that exchange equity is used for prorations
or other debit items, the taxpayer may receive taxable boot.
In summary, equity used to pay for transaction costs should not create taxable
boot. But equity used to pay for prorations and other debit items may create
taxable boot. Why should transaction costs and prorations be treated differently?
In both cases, the transaction is treated as if the taxpayer received cash
and paid the items through the closing agent. In both cases, an amount that
the taxpayer owes (whether the amount is owed to the taxpayer’s realtor
or to the buyer) is paid off using equity. However, transaction costs reduce
the gain realized on the exchange of property, while prorations and other debit
items do not. To the extent that amounts otherwise reflecting a taxable gain
must be paid to implement the transaction, the taxpayer realizes no gain in
an economic or tax sense. Prorations and other items, on the other hand, are
irrelevant in determining gain from a transaction. Prorations and other items
may affect how much cash the taxpayer gets at closing, the operating income
or loss from the property, and other important matters, but they do not affect
the amount realized from disposing of property in an economic or tax sense.
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