Gregory J. Rocca
Michael K. Phillips

Introduction to Section 1031 Exchanges

One of the last remaining tax shelters for real estate is an exchange of like-kind property held for business or investment, including rental real estate. Section 1031 of the Internal Revenue Code allows tax-free exchanges of investment property (not the owner's personal residence).  Section 1031 permits deferred exchanges in which the property is identified in 45 days and received in 180 days after the transfer of the old property.  The transaction must be structured as an exchange however, and the owner cannot actually or constructively receive the sale proceeds.  Owners use an exchange intermediary, such as Pacific Reality Exchange Inc., to ensure that they make a valid exchange instead of a taxable sale and reinvestment.   In general, if the owner "exchanges" into replacement property having equal or greater value and equity (net of exchange expenses) than the old property, no gain is recognized on the exchange under Section 1031. If the owner trades down in value or equity, gain is recognized only to the extent that the owner “trades down”in either value or equity (and receives cash or other property, or has net relief of debt). In contrast, owners who sell their property must recognize all of their gain. Owners sell their property if they actually or constructively receive the sales proceeds. Sellers must recognize all of their gain even if they immediately reinvest the sales proceeds in like-kind property.

The form of the transaction, as an exchange, is crucial. Owners engage an exchange intermediary, such as Pacific Realty Exchange, Inc., to meet the exchange requirement. The Section 1031 regulations provide a safe harbor for an exchange facilitated by a qualified intermediary. The intermediary enters into a written exchange agreement with the owner, sells the owner’s old property and uses the proceeds to acquire new property that is transferred to the owner. The new property must be identified in 45 days and received in 180 days after the transfer of the old property. Both the old and new property must be held for business or investment (the owner’s current residence does not qualify). Virtually all real estate is of “like kind” to other real estate (e.g., investment land, residential rental property, and commercial property may be exchanged for each other). By trading even or up in value and equity, the owner avoids paying income tax on the exchange The owner reinvests money that would have been lost in taxes and enjoys a return on the investment without any interest charge on the tax deferral. This is Section 1031 in a nutshell.

When an owner does a Section 1031 exchange, a key decision is choosing an exchange intermediary. Although the structure of a Section 1031 exchange is relatively simple, owners frequently have exchange questions. These questions may be basic or very complicated and require expert assistance. Questions often arise concerning matching properties in a multiple property exchange, the identification of replacement properties in the 45-day period (including naming multiple properties), the treatment of closing costs, the holding period for investment property, and converting property to a residence after an exchange. Other questions may involve mixed-use property (part rental, part residence), related party exchanges, multi-asset exchanges, build-to-suit exchanges, reverse exchanges, and exchanges by partnerships and other entities. An owner should select a proactive intermediary that is very sophisticated about Section 1031 and other tax provisions. By engaging a top-notch intermediary, the owner can avoid pitfalls, make informed decisions and ensure that the exchange qualifies for tax deferral. While most intermediaries charge comparable fees, the level of service and expertise varies widely.

Notwithstanding tax rate reductions for federal long-term capital gains, such gains remain subject to significant tax rates. Further, the amount of taxable gain may be greater than expected if the owner has a low tax basis from depreciation deductions or a prior exchange. In some cases where the owner has refinanced and taken out cash, tax on the gain may exceed the net sales proceeds. A Section 1031 exchange is usually the only way to avoid paying substantial tax on a gain in business or investment property.

Assume that an owner owns California depreciable property with a $600,000 gain (consisting of $300,000 in gain from prior depreciation and $300,000 of regular capital gain). For sales or exchanges after May 5, 2003, a 15% federal rate applies to long-term capital gains (property held more than one year). However, the portion of the gain that represents prior depreciation deductions continues to be taxed at a 25% federal rate. If the property is held one year or less, the gain is short-term capital gain and may be taxed at federal rates up to 35%. California imposes state income tax on capital gains of up to 9.3%. Withholding of 3 1/3% of the gross sales price also applies to a taxable sale of California property by an individual. The total gain of $600,000 may be subject to a combined tax rate of approximately 30% and $175,800 in federal and California income taxes computed as follows:

The effective federal tax on the gain could be much higher. A taxable gain is included in adjusted gross income. The owner may become subject to the alternative minimum tax and may also lose itemized deductions, exemptions and other tax benefits as a result of a higher level of income. To determine the overall tax on the gain, the owner’s accountant should run a complete tax projection.

Click here for a simple “Tax Calculation” sheet that may be used to estimate federal and state income tax on a gain.

Why Exchange?

The main benefit of a like-kind exchange is tax deferral. If no gain is recognized, through an exchange, the owner avoids paying income tax on the gain. In the example above, the exchange avoids $175,800 in tax on a $600,000 gain. Gain recognition is postponed indefinitely until the owner disposes of the replacement property in a taxable transaction. Some real estate owners are chronic exchangers. They exchange from property to property and never recognize any significant gain. The owners receive cash through cash flow sheltered by tax depreciation. If they need more cash, owners may receive non-taxable refinancing proceeds rather than taxable sales proceeds.

In this way, Section 1031 exchanges are a powerful wealth-building tool. This is true not only in a rapidly rising real estate market, but also in the long run. An exchange avoids the substantial tax “toll charge” every time a property is sold. The money continues to work for the owner in the next real estate investment rather than being forever lost in taxes. Since no interest is charged on the tax deferral, a tax deferred may become a tax saved over time. During the owner’s life, the investment of money in real estate that would have been spent on taxes generates a return. The cumulative return may, at some point, exceed the amount of taxes. For example, if the reinvested money that would have been paid in taxes generates an 8% per year return, the reinvested money will double in about 9 years. This is the so-called “rule of 72" ( 72 divided by a specified rate of return equals the number of years for principal to double). The calculation assumes the annual return is also reinvested and grows at the same rate. Thus, the total earnings on the money may exceed the taxes on the deferred gain over time.

Using the above example, assume (for convenience) that the $600,000 tax gain also equals the equity in the property. Tax gain is different from equity and may be more or less than equity depending on tax depreciation (which reduces tax basis without changing equity) and debt refinancing (which reduces equity without changing tax gain). The schedule below compares a taxable sale to a Section 1031 exchange. The exchange not only avoids $175,800 in current taxes, but results in more equity to reinvest, greater leverage and higher annual returns.

Sale v. Exchange

Income tax is permanently avoided when the owner dies. If the property is included in the deceased owner’s gross estate, the heirs take the property with a basis equal to its fair market value. The gain is eliminated as a result of the increased basis and never has to be recognized by the owner’s heirs. Income tax may also be permanently avoided if investment property is converted to a residence after an exchange. The property may be converted to a principal residence either by the owner or the owner’s donee (e.g., a child) if the property is gifted after an exchange. If the owner (or the owner’s donee) owns the property and lives there for 2 years and then sells the property, the gain may be excluded from income (up to $250,000 in gain for a single person and $500,000 in gain for married persons).

Aside from modestly higher transaction costs, the only disadvantage of an exchange is a reduced basis in the replacement property and lower depreciation deductions. Absent special facts, however, the benefit of tax deferral greatly outweighs the costs of an exchange, including smaller depreciation deductions. This is generally the result when all of the numbers are run on a present value basis.

Example. Assume the relinquished property has a value of $700,000, basis of $100,000 and gain of $600,000. The replacement property is acquired for $1,000,000. The basis in the replacement property after a Section 1031 exchange would be $400,000 ($1,000,000 less the $600,000 deferred gain), not the purchase price paid of $1,000,000. If 40% of the $400,000 exchange basis is allocated to non-depreciable land ($160,000) and 60% is allocated to the depreciable building ($240,000), $240,000 of basis would be available for depreciation deductions each year after the exchange. If the replacement property is purchased rather than acquired in a Section 1031 exchange, $600,000 (60% of $1,000,000) of basis would be available for depreciation deductions each year. If the replacement property is residential rental property, it will be depreciated over 27.5 years using the straight-line method. The difference in depreciation deductions would be approximately $13,091 per year (the difference in basis of $360,000 divided by 27.5 years). This additional depreciation would result in an annual tax savings of $4,582 at a 35% rate. If the replacement property is commercial property, it will be depreciated over 39 years, and the difference in depreciation deductions would be approximately $9,231 ($360,000 divided by 39 years). The additional depreciation would result in an annual tax savings of $3,231 at a 35% rate. But the upfront tax cost of a sale swamps the tax savings from additional depreciation. For example, the total tax payable on a $600,000 gain could be approximately $175,800 (as shown in the example above). If the taxpayer effects a Section 1031 exchange, there is an immediate tax savings of $175,800. This is much greater than the present value of the annual tax savings from additional depreciation deductions over 27.5 years or 39 years.

Exchange v. Sale

Form and substance distinguish a tax-free exchange from a taxable sale. An exchange is a reciprocal transfer of property for other property, as distinguished from a transfer for money consideration only. The form of the transaction must be an exchange, including proper exchange agreements and contractual relationships between the parties. In substance, the owner must not have actual or constructive receipt of the sales proceeds. For example, owners cannot simply sell their property and direct the escrow holder to deposit the proceeds to purchase new property. Transactions without an exchange accommodator are invariably treated as a taxable sale and reinvestment under case law. The reason is that the owner is not “exchanging” with any party and has constructive receipt of the sales proceeds through the escrow holder.

The Tax Court in Barker v. Commissioner, 74 T.C. 555, 561 (1980) has stated:

“ [The] touchstone of section 1031.... is the requirement that there be an exchange of like-kind business or investment properties, as distinguished from a cash sale of property by the taxpayer and a reinvestment of the proceeds in other property. The ‘exchange’ requirement poses an analytical problem because it runs headlong into the familiar tax law maxim that the substance of a transaction controls over form. In a sense, the substance of a transaction in which the taxpayer sells property and immediately reinvests the proceeds in like-kind property is not much different from the substance of a transaction in which two parcels are exchanged without cash. [Citation omitted.] Yet, if the exchange requirement is to have any significance at all, the perhaps formalistic difference between the two types of transactions must.... engender different results.”

To avoid a taxable sale and reinvestment, owners often exchange with an independent intermediary. The intermediary is a cooperative and sophisticated party with whom the owner effects a valid exchange. The owner and intermediary enter into an exchange agreement under which the owner transfers the old property in exchange for new property to be acquired by the intermediary. The intermediary completes the sale of the owner’s property and uses the sales proceeds to purchase new property that is transferred to the owner. Thus, the intermediary facilitates the owner’s exchange by (i) entering into an exchange agreement with the owner, (ii) entering into appropriate agreements with the buyer of the old property and the seller of the new property, and (iii) avoiding actual or constructive receipt of the sales proceeds by the owner. The intermediary must be a “qualified intermediary” or otherwise not be the owner’s agent. Under the Section 1031 regulations, the transaction safely qualifies as an exchange as long as the owner exchanges with a “qualified intermediary.” Persons related to the owner and agents of the owner are not qualified intermediaries. Thus, for a small fee, an independent intermediary creates an exchange out of what would otherwise be a taxable sale and reinvestment by the owner.

Types of Exchanges

Exchanges may be categorized based on the number of parties involved in the exchange and the timing of the exchange. There are two-party barter exchanges, three-party exchanges accommodated by a buyer or seller, and four-party exchanges using an intermediary. Most exchanges today are four-party exchanges with an intermediary. The buyer of the taxpayer’s relinquished property typically does not own the replacement property desired by the taxpayer. Further, a buyer or seller usually does not want to acquire and transfer other property in order to exchange with the taxpayer. Exchanges also vary based on the timing of the property transfers. Depending on when the replacement property is received by the taxpayer, an exchange may be a simultaneous, deferred or reverse exchange. The enclosed diagram, “Flow of Exchange Transaction,” shows the typical structure of a deferred exchange using an intermediary.

1. Simultaneous Exchange. In a simultaneous exchange, the transfer of the old property and the receipt of new property occur at the same time (or at least on the same day in an integrated transaction). The owner and intermediary enter into a Simultaneous Exchange Agreement. The intermediary acquires the owner’s property, sells it to the buyer, acquires the new property, and transfers it to the owner. These transactions are usually contractually interdependent and close concurrently. If the owner exchanges with a qualified intermediary, a safe harbor is provided so that the transfer and receipt of property is treated as an exchange. An owner may also effect a three-party simultaneous exchange with the buyer of the old property or the seller of the new property, but there is no safe harbor for such exchanges under the Section 1031 regulations.

2. Deferred Exchange. In a deferred exchange, the owner’s old property is transferred before the new property is received. The owner and intermediary enter into a Deferred Exchange Agreement. The intermediary acquires the old property, immediately sells it to the buyer, and receives the sales proceeds. The owner identifies new property in 45 days after closing. The intermediary uses the sales proceeds to purchase one or more identified properties, transfers the property to the owner, and completes the exchange in 180 days. The IRS endorses this procedure for effecting a “deferred exchange.” See Example 4 of Reg. Section 1.1031(k)-1(g)(8). The advantage of a deferred exchange over a simultaneous exchange is additional time. In a deferred exchange, the owner has more time to identify (45 days) and to receive (180 days) new property after transferring the old property. Further, the old property is closed before the owner is committed to buy new property.

The classic deferred exchange is the case of Starker v. United States, 602 F.2d 1341 (9th Cir. 1979). In Starker the taxpayer transferred the relinquished property to the buyer and the exchange could have been left “open” for up to 5 years. The taxpayer actually received all of the replacement property approximately two years after the transfer of the relinquished property. The key to the Starker decision was the taxpayer never had actual or constructive receipt of the exchange balance. In 1984, Congress limited the Starker decision by enacting Section 1031(a)(3) which imposes a 45-day identification requirement and a 180-day receipt requirement. In 1991, detailed regulations were finalized concerning deferred exchanges. The regulations provide additional rules for the identification and receipt of replacement property and restrictions on the taxpayer’s rights to receive money in a deferred exchange.

a. Identification Requirement.
The replacement property must be “identified” within 45 days after the transfer of the relinquished property. The statute does not define what constitutes “identifying” property. However, IRS regulations provide that replacement property is “identified” only if it is designated as replacement property in a written document signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent before the end of the 45-day period to either (i) the person obligated to transfer the replacement property to the taxpayer (e.g., the seller or intermediary) or (ii) any other person involved in the exchange other than the taxpayer or a disqualified person (e.g., a related party or an agent of the taxpayer). Examples of persons involved in the exchange include any of the parties to the exchange, an intermediary, an escrow agent, and a title company. Real property must be unambiguously described by a legal description, street address or distinguishable name. The taxpayer may identify alternative and multiple properties under the “3-property rule” (identify three replacement properties of any fair market value) or the “200-percent rule” (identify any number of replacement properties provided that their total fair market value does not exceed 200% of the fair market value of the relinquished property). Any replacement property received by the taxpayer before the end of the 45-day period is automatically treated as identified. Property that is not identified in the 45-day period does not qualify as replacement property under Section 1031.

b. Receipt Requirement.
The identified replacement property must be received on or before the earlier of (i) 180 days after the transfer of the relinquished property or (ii) the due date (including extensions) of the taxpayer’s return for the year of the transfer of the relinquished property. The receipt requirement creates a trap for the unwary. The exchange becomes taxable if the tax return for the year of the transfer of the relinquished property is inadvertently filed before the replacement property is received. If the replacement property has not been received by the due date of the return (e.g., April 15th), a valid extension must be filed. The receipt requirement guarantees that it will be known whether or not the transaction qualifies under Section 1031 before the taxpayer files his tax return for the year of the transfer of the relinquished property. This avoids the statute of limitations and other problems presented by a deferred exchange left “open” beyond the year of the transfer. Thus, a deferred exchange may cross tax years but the replacement property must be received before the return is filed. If a deferred exchange fails in the next year and the taxpayer then receives the sales proceeds, the taxpayer may defer some gain to the next year as an installment sale.

c. Cash Restrictions.
The regulations provide that the taxpayer cannot have any rights or immediate ability to receive exchange funds in a deferred exchange before the occurrence of one of the following “cash-out events”: (i) the end of the 45-day identification period if no replacement property is identified; (ii) the receipt of all replacement property that the taxpayer is entitled to receive under the exchange agreement; or (iii) the end of the 180-day exchange period. These cash restrictions must be expressly set forth in a written exchange agreement. While a deferred exchange remains open, exchange funds may be used only to acquire replacement property or to pay transactional expenses, such as earnest-money deposits, brokerage commissions, transfer tax and escrow fees. A taxpayer may receive money upon the transfer of the relinquished property directly from the buyer or at the escrow company at closing (but not from funds held by the intermediary). In that event, the taxpayer will recognize gain only to the extent of the funds received. For example, the taxpayer may receive $25,000 of $500,000 in sales proceeds directly from the buyer and have the remaining funds of $475,000 paid to the intermediary to acquire replacement property. The taxpayer would recognize only $25,000 of gain if the remaining funds are used to acquire replacement property. But the taxpayer cannot have rights to demand and receive the funds held by the intermediary until one of the above “cash-out events” occurs.

These cash restrictions are an essential part of a deferred exchange. If the taxpayer has the right or immediate ability to receive the exchange funds at any time, the transaction is a taxable sale, even if the funds are actually used to acquire replacement property. The possession of the unrestricted right to demand the funds is fatal, even if the right isn’t exercised. Taxpayers and intermediaries must abide by these cash restrictions. The premature receipt of cash may blow the entire exchange, disqualify previously received replacement property, and potentially infect other exchanges with the intermediary.

3. Reverse Exchange. In a true “reverse exchange,” the taxpayer receives the replacement property and subsequently transfers the relinquished property. For example, pursuant to an exchange agreement and without any cash consideration, A transfers Blackacre to T on February 1, 2004 and T transfers Whiteacre to A on March 1, 2004. The transaction is a deferred exchange as to A and a reverse exchange as to T. Reverse exchanges are usually accomplished through “parking transactions” in which the exchange itself takes the form of a current or future simultaneous exchange. The replacement property or the relinquished property is parked with an exchange accommodation titleholder (“EAT”). See Rev. Proc. 2000-37, 2000-40 IRB 308; Biggs v. Commissioner, 69 T.C. 905 (1978), aff’d 632 F.2d 1171 (5th Cir. 1980). Rev. Proc. 2000-37 provides an administrative safe harbor for a reverse exchange in which the replacement property (“exchange last” method) or the relinquished property (“exchange first” method) is parked with an EAT until the relinquished property is sold to a buyer. Under the safe harbor, all transactions (including the sale of the relinquished property to a buyer) must be completed within 180 days after the EAT acquires title. Reverse exchanges within the 180-day safe harbor are more complex and costly than other exchanges. Reverse exchanges outside of the 180-day safe harbor are even more complicated and expensive.

Reverse exchanges continue to be a last resort when a simultaneous or deferred exchange is impossible or impractical (i.e., the replacement property must be acquired before the relinquished property can be sold). These exchanges involve additional documents, including promissory notes and other agreements, and greater costs. There are two sets of closing costs for the parked property (transfer tax, title and escrow fees, supplemental property taxes, etc.) and higher intermediary and EAT fees. Unlike a simultaneous or deferred exchange, an accommodator must go on title, own the parked property and report the parked property on its tax returns until the relinquished property is sold to a buyer.

Section 1031 Requirements

In general, all gain or loss realized on the sale or exchange of property must be recognized. Section 1031 provides an exception to the general rule of recognition of gain and losses. Two rationales have been posited for the enactment of Section 1031 and its predecessors: (1) the continuity-of-investment or liquidity rationale; and (2) the administrative-convenience rationale. The continuity-of-investment rationale is based on the fact that “the taxpayer’s money is still tied up in the same kind of property” and “the new property is substantially a continuation of the old investment still unliquidated.” Under these circumstances, Congress determined that a taxpayer should not be charged with tax on his theoretical profit. The calculation of gain or loss is deferred until it is realized in cash, marketable securities, or other property not of like kind. The administrative-convenience rationale is based on the administrative burden of valuing property in “thousands of horse trades and similar barter transactions.” The underlying purposes of Section 1031 are tied to the exchange requirement. Gain is recognized in a like-kind exchange to the extent that the taxpayer receives cash or other property not of like kind.

The specific requirements of Section 1031 are as follows:

• Same Taxpayer. The same taxpayer that starts the exchange must complete the exchange. A disregarded entity, such as a revocable trust or single-member LLC, is treated as the same taxpayer. A husband and wife are different taxpayers, as are partnerships and partners, and corporations and shareholders. This matching requirement presents problems when relinquished property is owned by one spouse and both spouses want to go on title to replacement property, or when relinquished property is owned by a partnership and the partners want to do separate exchanges.

• Exchange Requirement. The form of the transaction must be an exchange of relinquished property for replacement property. The taxpayer must exchange property with some other party, including an intermediary. A valid exchange involves bilateral and reciprocal commitments (e.g., the transfer of Blackacre for Whiteacre with another party). An exchange is distinguished from a taxpayer’s unilateral sale of the relinquished property followed or preceded by the taxpayer’s unilateral purchase of another property. A sale is evidenced by (i) the absence of an exchange agreement with another party and (ii) the taxpayer’s actual or constructive receipt of the sales proceeds.

• Qualified Property. Only a transfer of property qualifies for like-kind exchange treatment; the provision of services does not. This presents complications in exchanges involving improvements. The improvements must be constructed before the taxpayer receives title, and exchange funds cannot be used to pay for construction services performed thereafter. Neither the relinquished property nor the replacement property may be a type of property expressly excluded under Section 1031(a)(2), such as property held primarily for sale, stocks or bonds, partnership interests and promissory notes. The taxpayer cannot receive an interest in a partnership as replacement property but may receive a direct ownership interest as a tenant in common.

• Qualified Use. Both the relinquished property and the replacement property must be held by the taxpayer for productive use in a trade or business or for investment at the time of the exchange. Property held as the taxpayer’s personal residence is not held for a qualified use. The statute does not specify how long property must be held for business or investment. A minimum holding period of more than one year is recommended by many tax advisors (consistent with the holding period for “long-term” capital gains), but there is no bright-line test. Several cases have allowed shorter holding periods and disallowed longer holding periods than one year depending on the facts.

• Like-kind Property. The replacement property must be of “like kind” to the relinquished property. A broad like-kind rule applies to real estate under which virtually any real estate is treated as being of like kind to other real estate (e.g., residential rental property, commercial real estate, unimproved land, a tenancy-in-common interest, or a leasehold interest with 30 years or more to run). Due to the liberal like-kind rule for real estate, owners can dramatically change the nature of their real estate holdings free of tax (e.g., owners may exchange actively managed apartment buildings for triple-net leased commercial property). Narrow like-kind rules apply to personal property (e.g., car for car, airplane for airplane, computer for printer). Under the regulations, goodwill is never of like kind, even if the businesses are the same or very similar.

• Time Requirements. In a deferred exchange, the replacement property must be (a) identified within 45 days after the relinquished property is transferred (the “identification requirement”), and (b) received by the taxpayer on or before the earlier of (1) 180 days after the date on which the taxpayer transfers the relinquished property or (2) the due date, including extensions, for the taxpayer’s return for the year in which the relinquished property is transferred (the “receipt requirement”). As noted above, the regulations provide detailed rules concerning the identification of replacement property. Under these rules replacement property must be described in a writing signed by the taxpayer and sent to another party involved in the exchange before the end of the 45-day period. A limited number of alternative or multiple properties may be identified under the 3-property rule, 200% rule or 95% rule. See Reg. Section 1.1031(k)-1(c)(4). Replacement property received within the 45-day period is automatically treated as identified.

Related Party Exchanges

Special rules limit exchanges involving related persons. Related persons include spouses, parents, children, brothers and sisters, and entities more than 50% owned by the taxpayer or related persons. Related persons do not include nephews, nieces, cousins, in-laws, and entities that are owned 50% or less by the taxpayer or related persons. After a direct exchange between related persons (e.g., the taxpayer transfers Blackacre to his son in exchange for the son’s transfer of Whiteacre to the taxpayer), both parties must hold their properties for 2 years after the exchange (e.g., neither the taxpayer nor the son can sell Blackacre or Whiteacre for 2 years). If either party sells the property in the 2-year period, the prior exchange becomes taxable for both parties (including the party that did not sell its replacement property). This rule prevents tax avoidance by related parties through an exchange of low-basis property for high-basis property followed by a sale of the low-basis property within 2 years.

If the taxpayer acquires replacement property from a related party seller (including an acquisition through an intermediary), the taxpayer’s exchange generally will not qualify under Section 1031. The exchange will be taxed even though the taxpayer himself doesn’t receive any cash. See Section 1031(f)(4); Rev. Rul. 2002-83. The related party’s receipt of cash (including the exchange funds) upon its sale of the replacement property disqualifies an otherwise valid exchange by the taxpayer. Thus, a taxpayer generally should not identify or attempt to receive replacement property owned by a related party. A possible exception is when the related party successfully completes its own Section 1031 exchange into other property (in lieu of receiving sales proceeds). Both parties would then hold their replacement properties for 2 years.

The “Napkin Test” for Exchanges

Few taxpayers comprehend all of the detailed computations involved in exchanges but most understand the “napkin test.” The complex rules for computing gain recognized from an exchange and the basis of replacement property may be restated by three simple rules.

• Rule One: To totally defer gain, the taxpayer must trade even or up in both value and equity from the relinquished property to the replacement property.

• Rule Two: If the taxpayer trades down in value and/or equity, the taxpayer recognizes gain to the extent of the decrease in value or equity, whichever is greater, reduced by exchange expenses.

• Rule Three: The taxpayer’s basis in the replacement property equals the value of the replacement property less the deferred gain.

An exchange must balance. Taxpayers must account for all of the equity from the relinquished property. Equity is the sales price of the property less the amount of liabilities. That equity may be either: (i) reinvested in replacement property or used to pay exchange expenses (nontaxable); or (ii) received by the taxpayer as boot, including the use of equity to pay closing costs that are not exchange expenses (taxable). Taxpayers must also account for any increase or decrease in value from the relinquished property to the replacement property. An increase in value adds to the taxpayer’s basis in the replacement property. A decrease in value (net of exchange expenses) means that the taxpayer has received taxable boot.

A trade down in value or equity is caused by either: (1) the taxpayer receiving “boot” in the form of cash instead of reinvesting that equity in the replacement property (trade down in equity); or (2) the taxpayer receiving replacement property of lesser value than the relinquished property by reinvesting the equity but incurring less liabilities for the replacement property than those liabilities given up on the relinquished property (trade down in value). If the taxpayer trades down in either value or equity (net of exchange expenses), the taxpayer must recognize gain to the extent of the decrease (up to the amount of his entire realized gain).

Example 1. Andy exchanges an apartment house with a fair market value of $220,000, debt of $80,000, equity of $140,000, and an adjusted basis of $100,000. Andy receives an office building with a fair market value of $250,000, debt of $150,000, equity of $100,000, and cash of $40,000. Andy’s exchange expenses are $10,000. Andy pays the exchange expenses out of the cash received and is left with $30,000.

Rule One: Andy traded up in value ($220,000 to $250,000), but not in equity ($140,000 down to $100,000); therefore, Andy will recognize some gain on the exchange.

Rule Two: Andy is taxed on the greater of the trade down in value ($0) or equity ($40,000) reduced by exchange expenses ($10,000), but only to the extent of Andy’s realized gain. Andy’s realized gain is $110,000 ($220,000 less $100,000 basis less $10,000 exchange expenses). Andy’s trade down in equity of $40,000 is reduced by exchange expenses of $10,000, so Andy trades down in equity by $30,000 after exchange expenses. This amount also equals the net cash received by Andy. Andy must recognize $30,000 of the $110,000 gain and defers recognition of the remaining gain of $80,000.

Rule Three: Andy’s basis in the replacement property equals $170,000. This amount equals the $250,000 value of the replacement property less the $80,000 gain deferred on the exchange ($110,000 of realized gain less $30,000 of recognized gain). The lower basis in the replacement property preserves the remaining gain for future recognition. If Andy sells the replacement property for $250,000, all of the realized gain of $110,000 will be recognized: $30,000 of gain is recognized now on the exchange and $80,000 of deferred gain is recognized later on the sale of the replacement property.

To avoid the taxable receipt of cash caused by a trade down in equity, Andy could increase the debt on the relinquished property or reduce the debt on the replacement property by $30,000. Then Andy would trade even in equity and up in value and avoid recognition of any gain. Andy could also use the remaining $30,000 of equity to acquire additional replacement property. Alternatively, Andy may want to receive some taxable boot in the form of cash if Andy has passive or capital losses available to offset the gain. For example, if Andy has $30,000 of losses in the above example, Andy could use the losses to offset the $30,000 gain recognized on the exchange.

Example 2. Ben exchanges an office building with a fair market value of $250,000, debt of $150,000, equity of $100,000 and an adjusted basis of $120,000. Ben receives an apartment house with a fair market value of $220,000, debt of $80,000 and equity of $140,000. Ben pays $40,000 in cash to account for the greater equity in the replacement property. Ben’s exchange expenses are $12,000.

Under the “napkin test,” Ben traded down in value and must recognize some gain on the exchange even though Ben traded up in equity. Ben must recognize gain of $18,000. This amount is the greater of the trade down in value of $30,000 ($250,000 less $220,000) or equity ($0), less $12,000 in exchange expenses. Ben in fact traded up in equity by $40,000. But since Ben traded down in value, Ben must recognize gain of $18,000 ($30,000 less $12,000 exchange expenses). Ben’s realized gain is $118,000 ($250,000 less $120,000 basis less $12,000 exchange expenses). Technically, Ben must recognize gain because Ben was relieved of $150,000 of debt and acquired the new property subject to $80,000 of debt, resulting in $70,000 of liability relief. The net liability relief is treated the same as cash received by Ben. But Ben is able to offset the liability relief of $70,000 by the cash paid of $40,000, resulting in net boot received of $30,000. This is the amount of the decrease in value. The “napkin test” is merely a short-cut to the same result.

What is Ben’s basis in the replacement property? Ben’s basis is $120,000 which is equal to the $220,000 value of the replacement property less the deferred gain of $100,000. The deferred gain of $100,000 equals the gain realized of $118,000 less the gain recognized of $18,000. All of the realized gain of $118,000 will be recognized if Ben sells the replacement property for its value of $220,000: $18,000 is recognized now on the exchange and $100,000 will be recognized later upon the sale of the replacement property ($220,000 less $120,000 basis).

Without changing the economics of the exchange, the tax results cannot be improved for Ben by balancing the debt or equity in a different way. The problem for Ben is that he has traded down in value and no adjustments to the debt or equity will change that fact. For example, Ben might reduce his debt on the office building by $18,000 (from $150,000 to $132,000) in an attempt to avoid the $18,000 in boot received. But this would simply reduce Ben’s cash payment by $18,000. Ben would only need to pay $22,000 to compensate for the greater equity value in the replacement property (equity of $140,000) since Ben’s equity in the relinquished property is now $118,000 ($250,000 value less $132,000 reduced debt). Under the napkin test, Ben will still trade down in value by $30,000 and must recognize gain of $18,000 ($30,000 less $12,000 exchange expenses). Ben will now have liability relief of $52,000 ($132,000 old debt less $80,000 new debt). This is offset by the $22,000 cash payment to equalize equity values, resulting in $30,000 net boot received by Ben. The same result occurs if the debt on the new property is increased by $18,000. Ben’s cash payment to balance the equity will be reduced by $18,000, with no change in the net boot received by Ben. The same result occurs if the parties agree to decrease the agreed value of the relinquished property by $12,000 (from $250,000 to $238,000) and have the other party pay Ben’s exchange expenses of $12,000. In that case, Ben will trade down in value by $18,000 ($238,000 less $220,000) with no exchange expenses, and Ben must still recognize $18,000 of gain.

No readjustment of the debt or equity on the properties will change the fact that Ben trades down in value in Example 2 and must recognize gain as a result. This is the value constraint of Section 1031. A taxpayer must trade even or up in value on an exchange to avoid recognition of all gain. To avoid recognition of all gain, Ben must acquire additional replacement property worth $18,000 or more in Example 2.

In summary, careful tax planning (i.e., balancing the debt and equity in a different way) would eliminate recognition of gain by Andy in Example 1. Readjusting debt and equity presents a tax-saving opportunity in every situation in which the taxpayer would otherwise trade down in equity but even or up in value (Andy’s case). But readjusting debt and equity will never improve the tax result for a taxpayer who trades even or up in equity but down in value (Ben’s case). If Ben does not want to recognize any gain, Ben must acquire more replacement property.

Liabilities

In determining the net boot received by the taxpayer and taxable gain, liabilities incurred by the taxpayer for the replacement property do not offset cash received by the taxpayer from the relinquished property. Put another way, “mortgage boot” given does not offset “cash boot” received. This is the basis of the rule that trading down in equity causes gain to be recognized even though the taxpayer trades even or up in value (Andy’s case in Example 1 above).

New financing obtained by the taxpayer for the replacement property will offset liability relief from the relinquished property, but not cash boot received. The new loan should be treated as a liability assumed by the taxpayer rather than cash paid. See Behrens v. Commissioner, T.C. Memo 1985-195. 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.

A loan pay-off on the closing of the relinquished property is not treated as cash received by the taxpayer. Rather, the loan pay-off is treated as liability relief that may be offset by liabilities incurred or cashed added for the replacement property. 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). The taxpayer is merely a conduit for the 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. 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 IRS Private Letter Ruling (“PLR”) 9853028.

Non-mortgage or unsecured liabilities may be netted against mortgage liabilities, but the unsecured liabilities must be reckoned with as part of the exchange. Thus, the transferee of the relinquished property should agree to pay and be expected to satisfy the liabilities. There is no express requirement in the regulations that unsecured liabilities otherwise relate to the property or to the transaction. Nevertheless, the IRS may take the position that any unsecured liabilities paid off at the closing of the relinquished property must be connected to the relinquished property. Otherwise, the taxpayer could cause exchange proceeds to be used to pay off unrelated, unsecured liabilities of the taxpayer, such as personal loans and credit card debt. If 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 to the property or the transaction in order to establish that these unsecured liabilities were required to be paid off as part of the closing.

Promissory Notes

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). The note qualifies for installment sale reporting of the gain (recognition of gain as principal payments on the note are received). If the taxpayer wants to avoid tax on the note, the taxpayer can add cash and separately finance the buyer’s note as a third-party lender before the closing of the relinquished property. Alternatively, the note may be made payable to the exchange intermediary. The intermediary can subsequently sell the note or otherwise convert it into cash and use the proceeds to acquire replacement property. If the taxpayer subsequently adds cash to buy the note from the intermediary and the cash is used to acquire replacement property, the taxpayer should avoid the receipt of boot, but this result is less clear than the other alternatives.

Transaction Costs

Transaction costs include “exchange expenses.” Exchange expenses are costs of disposing of the relinquished property, acquiring the replacement property or the exchange itself. 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 CB 468; Mercantile Trust Co. of Baltimore v. Commissioner, 32 BTA 82 (1935); PLR 8328011. For example, assume that a taxpayer receives $30,000 of cash in the exchange (including cash deemed to be received as a result of a reduction in equity or value in the exchange). If the taxpayer pays $25,000 in brokerage commissions, the taxpayer will recognize only $5,000 of taxable income from the receipt of the cash ($30,000 less $25,000 in exchange expenses). In addition to brokerage commissions, other transaction costs should be deductible if “paid out in connection with the exchange.” See PLR 8328011 (allowing undefined “exchange expenses” to offset boot received). These costs are referred to as “exchange expenses” on IRS Form 8824 (used to report like-kind exchanges). Such costs are not specifically defined anywhere but should include costs that are typically: (i) deducted by the seller from the gross sales proceeds in a taxable sale as selling expenses; (ii) nondeductible by a buyer but capitalized and added to the basis of the property acquired as purchase costs; or (iii) costs specifically related to the fact that the transaction is an exchange, such as intermediary or legal fees. Such costs include brokerage commissions, finder’s fees, title insurance premiums, escrow fees, legal fees, property inspection fees, intermediary fees, transfer taxes and recording fees. Many of these costs are typically found on a closing statement, but some may be paid outside of closing.

“ Exchange expenses” are not the same 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 also other items that are typically found on a closing statement but are not exchange expenses, such as prorated rents, mortgage interest, and property taxes. 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 transferee 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. Other transactional items that are debited to the taxpayer and paid with exchange equity will be cash boot, but items credited to the taxpayer will be treated as cash paid by the taxpayer and can offset the taxable boot from non-exchange expenses.

Security deposits and prepaid rent are non-exchange expenses. It is unclear whether these items may be treated as “liabilities” assumed as part of the exchange or as cash boot. 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 has offsetting credits or pays the buyer of the relinquished property a sum equal to the security deposits or prepaid rent, this avoids taxable boot to the taxpayer. 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, and the prepaid rent will be treated as rental income to the taxpayer and not as gain from the exchange.

Loan fees, points, lender’s title insurance, assumption fees, and other costs related to the acquisition of a loan for the replacement property 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. The costs related to obtaining a loan are amortized over the life of the loan rather than the property purchased with the loan. 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 loan costs.

If the taxpayer desires to avoid recognition of all gain on the exchange, the taxpayer may add cash to the closing of the relinquished property to cover the charges for non-exchange expenses. Similarly, deposits or credits in excess of the exchange proceeds for the acquisition of the replacement property will be treated as cash paid by the taxpayer. The additional funds will offset the taxable boot caused by loan costs and any other non-exchange expenses in connection with the replacement property.

Form 8824 Like-Kind Exchanges

Like-kind exchanges must be reported on IRS Form 8824. The amounts reported on Form 8824 determine the amount of gain or other income that must be recognized on the exchange and carried to other schedules on the tax return, such as Schedule D or Form 4797. In working from typical closing statements to a completed Form 8824, various closing costs must be taken into account. “Closing costs” include “exchange expenses,” prorations and other items that appear on a typical closing statement, except for the value of the property and liabilities. “Exchange expenses” are amounts charged to the taxpayer (debits) for selling expenses, acquisition expenses and other exchange expenses, such as intermediary fees. “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, and association dues. “Other items” include debits or credits for loan costs, binder rebates, and other cash amounts paid into or received from escrow. As noted above, the treatment of certain closing costs is unclear. Depending on the facts, security deposits, prorated rents, prorated taxes and other items may be viewed as obligations with a fixed or determinable date of maturity and arguably may be categorized as “liabilities.” The schedule below summarizes the closing statements for the relinquished property and replacement property in a simultaneous exchange. All closing costs on the statements have been classified and aggregated as either “liabilities,” “exchange expenses” or other boot items (including loan costs and prorations that are not treated as liabilities).

Assume that the adjusted tax basis of the property transferred is $600,000 (original cost of $1,000,000 less $400,000 depreciation allowable). Thus, the taxpayer has a large gain inherent in the old property of $1,400,000 ($2,000,000 less $600,000), ignoring transaction costs. The question is whether the taxpayer recognizes any gain on this exchange. The taxpayer traded up in value from a $2,000,000 to $3,000,000 property, but his equity was reduced from $800,000 on the old property ($2,000,000 less $1,200,000) to only $620,000 on the new property ($3,000,000 less $2,380,000). Does the fact that his equity was reduced by $180,000 in the exchange mean that the taxpayer must recognize gain of $180,000? The answer depends on how transaction costs are treated in computing gain recognized in an exchange.

In the above example, $190,000 in exchange expenses were paid by the taxpayer ($150,000 in connection with the old property and $40,000 related to the new property). The exchange expenses exceed the reduction in equity by $10,000 ($190,000 less $180,000). Total credits for prorations and other items (including cash added to the exchange) are $70,000 for the new property, while total charges for other items are $60,000 for the old property. The taxpayer paid additional cash or received other credits for “other boot items” to account for this net credit of $10,000. In effect, $10,000 in cash was added to the exchange by the taxpayer and used to pay the remaining $10,000 in exchange expenses.

Thus, the taxpayer received no cash or other property not of like kind in this exchange. Rather, he added $10,000 to the exchange and used $180,000 of his equity from the old property to pay the $190,000 in exchange expenses. The answer to the above question is that the taxpayer should not recognize any gain on this exchange. The taxpayer did not exit the exchange transaction with $180,000 in cash to do with as he pleased. He simply paid his realtor, title company, escrow company, attorney, exchange intermediary and other exchange expenses. Of course, if exchange expenses were only $80,000 in the above example and the taxpayer exited the exchange with $100,000 in his pocket, he should recognize gain of $100,000 in that case. The schedule below shows the key line entries on IRS Form 8824 for this exchange.

Form 8824 Computations

Notes

(1) The instructions to line 15 of Form 8824 state that the sum of the following is included on line 15:
(i) any cash paid to the taxpayer by the other party;
(ii) the fair market value of any other (non-like-kind) property received by the taxpayer; and
(iii) any net liabilities assumed by the other party - the excess, if any, of liabilities assumed by the other party on the old property over the total of: (a) any liabilities assumed by the taxpayer on the new property, (b) cash paid by the taxpayer to the other party, and (c) the FMV of any other (not like-kind) property given up by the taxpayer.

Exchange expenses are then used to reduce the sum of the above amounts (but not below zero). Taking into account exchange expenses, no cash or other boot was received by the taxpayer in this example, so zero is entered on line 15.

(2) The instructions to line 18 of Form 8824 state that the sum of the following is included on line 18:

(i) the adjusted basis of the old property;
(ii) exchange expenses, if any (except for expenses used to reduce the amount reported on line 15); and
(iii) net amount paid to the other party - the excess, if any, of the total of: (a) liabilities assumed by the taxpayer on the new property, (b) cash paid by the taxpayer to the other party, and (c) the FMV of any other (not like-kind) property given up by the taxpayer, over liabilities assumed by the other party on the old property.

In this case, there were $190,000 in exchange expenses and $180,000 was used to reduce the amount on line 15 (total other credits of $70,000 plus $180,000 of exchange expenses offset $250,000 in total other debits in computing the amount on line 15). Accordingly, the net exchange expenses (or net cash paid) that was not used to reduce the amount of boot on line 15 was $10,000. The computation for line 18 in the example is as follows:

Mixed-Use Property

A taxpayer may exchange property that is used partially as business or rental property and partially as a personal residence for property with similar uses. For example, a taxpayer may own an apartment house, such as a duplex or triplex, and use one of the units as a personal residence. The taxpayer will then exchange the apartment house for another apartment house, which the taxpayer will also use partially as a residence. A taxpayer may also exchange a farm containing a personal residence for another farm also containing a personal residence. In these situations, the taxpayer is exchanging like-kind property and other property (the personal residence portion) for like-kind property and other property. The gain on the personal residence portion of the property may be excluded under Section 121 if the taxpayer owned and used that portion of the property for 2 out of the last 5 years ending on the date of the sale.

To compute the gain or loss from the exchange and the basis of the replacement property, the fair market value, debt and equity of each property must be allocated between the two uses. This allocation can be made by any reasonable method. For example, the allocation for an apartment house used partially as a personal residence may be based on the respective square footage of the personal residence and rental portion. The exchange of the rental portions of the properties is treated as a separate transaction under Section 1031. See Rev. Rul. 59-229, 1959-2 C.B. 180; Sayre v. United States, 163 F. Supp. 495 (SD W Va 1958). The “napkin test” is applied to the rental portions of the properties. The taxpayer must trade even or up in value and equity on the rental portions of the properties to avoid recognition of gain.

Converted Property

Section 121 allows each owner to exclude up to $250,000 of gain on the sale or exchange of his principal residence ($500,000 of gain for married persons). The gain is completely eliminated and never has to be recognized. The taxpayer must own and use the property as his principal residence for 2 out of the last 5 years ending on the date of sale. Any excess gain over $250,000 or $500,000 is taxable and can no longer be rolled over into a new residence.

If property was the principal residence of the taxpayer for 2 out of the last 5 years for purposes of Section 121 but is converted to a rental property so as to qualify under Section 1031, the taxpayer may get the best of both worlds. Both Sections 121 and 1031 may apply to an exchange of a residence converted to business or investment property in the 5-year period. The governing statutes seem to permit this result. Section 121 applies to a sale or an exchange of property. Section 1031 may also apply to an exchange of converted property if the property is held for investment at the time of the exchange.

Example. The taxpayers own a luxury condominium unit with a $3 million gain. They have lived at the unit for the last 2 years and desire to move out and convert the property to a rental property. They rent the property to a third party at a fair market rent for 2 ½ years without any attempts to sell the property. After 2 ½ years of renting the property, they exchange the property for another luxury condominium unit which is rented out. At the time of the exchange, the old unit has a value of $5 million and gain of $3.5 million. The new unit has a value of $4.5 million. Assume that the exchange meets all of the other requirements of Section 1031, except that the taxpayers receive $500,000 in boot. What are the tax consequences of this transaction? How is the transaction reported?

First, the taxpayers should qualify for the $500,000 exclusion of gain under Section 121. They owned and used the property as their principal residence for 2 years during the 5-year period ending on the date of the exchange. Second, the requirements of Section 1031 should be met with respect to the exchange, except that gain must be recognized to the extent of the boot received. On these facts, the taxpayers should be deemed to have held the old property for investment under Section 1031 since they actually rented the property for 2 ½ years without attempting to sell it. The new property will also be rented out and held for investment. The like-kind exchange is reported on Form 8824. The taxpayers received $500,000 so the gain recognized on the exchange is $500,000 (line 22 of Form 8824). The basis in the new unit is $1.5 million which is equal to the value of the new unit ($4.5 million) less the deferred gain ($3 million). The $500,000 of gain recognized on the exchange is carried to Form 4797 but the Section 121 exclusion of $500,000 is shown as an offsetting “loss” on that form. In short, the taxpayers receive $500,000 without paying tax due to the Section 121 exclusion, and they defer recognition of the remaining $3 million in gain through a Section 1031 exchange.

Sections 121 and 1031 are not complementary provisions, however, when the relinquished property is converted to a personal residence of the taxpayer. Only Section 121 may apply to property converted to a personal residence at the time of the sale Section 1031 excludes personal residences by implication since it only applies to property held for productive use in a business or for investment at the time of the exchange.

Conclusion

Despite lower federal capital gains rates for property held more than one year, Section 1031 exchanges remain very popular. This is especially true in states with high income tax rates, such as California (9.3% rate). A Section 1031 exchange provides an even greater federal tax benefit for property held for less than one year (gain taxable at ordinary rates up to 35%), and for property that has been depreciated (depreciation gain taxable at 25% rate). Section 1031 is a powerful wealth-building tool for real estate investors. Through an exchange, all of an owner’s equity may be reinvested in new property without payment of income tax, resulting in greater cash flow, leverage and appreciation in value.