"Cash Out" with a 1031 "Like-Kind" Exhange

By: Stephen M. Breitstone
New York Real Estate Journal
February 18, 2003

When selling commercial real estate, the use of a "like-kind" exchange under IRC Section 1031 is often considered -- but less frequently implemented. This is usually because of the practical difficulties of lining up an appropriate replacement property within the rigid 45 day identification period after the sale and closing within 180 days after the sale as required under Section 1031(a)(3). It is extremely difficult within those time constraints to find the appropriate blackacre that would be acceptable as a substitute investment for the discriminating seller.

However, that difficulty often can be overcome by acquiring credit tenant net lease ("CTL") property as an interim step. This transaction can permit the seller to "cash out" by refinancing the CTL property shortly after its acquisition. The refinancing proceeds can be reinvested virtually without any time constraints. It is thus possible to circumnavigate the time restrictions that normally apply under IRC Section 1031. Once fully leveraged, the CTL property will not generate cash flow after payment of debt service. But the proceeds of the refinancing can be invested in property that produces a yield.

Financing out before a Section 1031 like-kind of exchange will result in taxable "boot" under Section 1.1031(d)-2 of the Treasury Regulations. However, the conventional wisdom is that financing out after -- even immediately after -- will not result in taxable "boot".

There are some important income tax considerations that must be addressed in planning for a CTL like-kind exchange. For example, as the mortgage on the CTL property is amortized, there will be some "phantom" ordinary income, which will be taxed at a higher rate than the capital gains rate that would apply to the sale. However, the ordinary income will be deferred and recognized over the term of the mortgage. In addition, the tax on the ordinary income may be completely avoided if the taxpayer dies and the estate receives a basis step up under IRC Section 1014. Note that if the cash proceeds of the refinancing are used to purchase this property, the depreciation from that property will be available to shelter the phantom income.

Finally, it is necessary to be mindful of the interest tracing rules of Temp. Reg. Section 1.163-8T. Under those rules, the deductibility of the interest on the mortgage resulting from the refinancing, will depend upon how the proceeds are invested. For example, if the proceeds are invested in other commercial real estate, the interest will be deductible against all real estate rental income. If the proceeds are invested in bonds, the interest will be deductible only against similar "net investment income". If the proceeds are invested in personal use items, the interest on the refinancing will not be deductible. It is thus essential to track the use of the proceeds and manage the investments to protect the interest deduction.