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Avoiding tax on "boot" used for repair.

Sec. 1031 allows a tax-free exchange between two or more like-kind properties. Under certain circumstances, a taxpayer may find it necessary to use some proceeds from the sale of the relinquished property to repair or remodel the replacement property. The proceeds not directly invested in the purchase of the new property are referred to as "boot" and are fully taxable.

When remodeling and repairs are deemed necessary, to prevent this unnecessary taxation, taxpayers should do the following:

1. Prior to selling the relinquished property, the "buyer" could refinance or place a note and second deed of trust against the property. This reduces the net amount received from the sale of the original property. The loan on the relinquished property allows the buyer to receive the amount of cash necessary to repair or remodel the replacement property completely tax-free.

Caveat: The amount of debt on the relinquished property and the replacement property would need to be compared, to ensure that additional gain is not recognized.

2. The buyer could request the seller of the replacement property to make the appropriate repairs and desired modifications to the property prior to the closing date. The replacement property's increased value allows the taxpayer to directly apply all of the proceeds from the relinquished property. This scenario hinges on the assumption that the seller is able and willing to provide the repairs to the buyer's specifications.

3. The buyer could request the intermediary to loan the seller the amount necessary to remodel and repair the property by securing a deed of trust on the replacement property. The downside to this structure is the time constraint on the remodeling period and the fact that the remodeling contractors will be held responsible to the seller instead of the buyer.

4. Lastly, the taxpayer could require the intermediary to close on the replacement property. The intermediary would take title to the replacement property and, within 180 days, use the funds held from the sale of the relinquished property to make the necessary repairs and modifications. The intermediary then transfers the tide of the property to the taxpayer. This allows the taxpayer to repair and remodel the replacement property without receiving any taxable boot or incurring any refinancing fees.

Caveat: The IRS may closely scrutinize these situations to determine if a legitimate exchange has taken place.

FROM WARREN HEATLEY, CPA, KANSAS CITY, MO
COPYRIGHT 1999 American Institute of CPA's
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Title Annotation:real property tax-free exchanges
Author:Heatley, Warren
Publication:The Tax Adviser
Geographic Code:1USA
Date:Feb 1, 1999
Words:394
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