Taxable Boot Related to Prepaid Rent and Security Deposits
In a standard closing (not involving a 1031 exchange), it is typical for the prepaid rent and security deposits being held by the seller to be treated as a credit to the buyer at closing. In that context, the net amount paid to the seller for the property at closing is simply reduced. However, this same practice in connection with a sale of relinquished property in a 1031 exchange will inadvertently result in boot, and the amount of prepaid rent and security deposits retained the by taxpayer will be taxable.
This happens quite frequently in exchange transactions and the taxpayer and his advisors are unwittingly subjecting the taxpayer to taxable gain. Rent and security deposits are income items and cannot be offset against gain otherwise recognized in an exchange.
Let’s Look at an Example
Take the case of a taxpayer selling a multi-family apartment building for $500,000. Let’s assume he is holding $20,000 in rent he received representing the balance of days in the month where the buyer is actually in ownership of the property (prepaid rent). Let’s also assume that the total of security deposits held by the taxpayer is $25,000. So the taxpayer has a total of $45,000 of cash in his pocket. Let’s also assume for the sake of simplicity that the property has no mortgage and nominal closing costs.
If the taxpayer gives a credit to the buyer for this $45,000 amount, the net value received for the property would be $455,000. However, this is problematic in a 1031 exchange as the $45,000 cannot be offset against gain and any boot will be taxable. To avoid taxable boot the taxpayer would have to buy replacement property equal to or greater than the net value, in this case $500,000, without the offset of the prepaid rent and security deposits.
How Is this Problem Corrected?
In a closing involving a 1031 exchange, preparers of settlement statements should ignore the customary practice of providing credits for rent and security deposits. Rather, the taxpayer should transfer those income items directly to the buyer.
Using the example above, with rent and security credits paid directly to the buyer, the net sale price of the apartment building would be $500,000 and if the taxpayer traded up or even for replacement property, there would be no boot.
Do Real Estate Taxes Credited to a Buyer Result in the Same Issue?
Real estate taxes are looked at a bit differently. Generally at a closing, the seller will give the buyer a credit for taxes that have accrued while the seller was in ownership but which are not yet due and payable. The payment of real estate taxes generally are billed and paid in arrears. So the taxpayer has not received income on that sum, rather it is a liability of the property.
The treatment of the real estate tax liability is similar to the way debt (mortgage) is treated. Under exchange rules, any debt paid off upon the sale of a property must be replaced by new debt on the replacement property in an equal or greater amount. "Relief” of real estate tax liability due to a credit of that amount to the buyer can be offset by equal or greater tax liability the taxpayer may receive from the seller of the replacement property.
Are These Same Considerations Relevant to the Replacement Property Closing?
Similar issues arise when there are credits to the taxpayer at closing. Credit that the taxpayer receives for these items will be treated as taxable cash boot. Again, a credit given to the taxpayer will reduce the amount that the taxpayer pays to buy the property, however a check directly from the seller to the taxpayer for these amounts avoids the result of taxable boot. In the event a credit is given, the rent is treated as rental income. The security deposit amount is not characterized as income since it is being held for return to the tenant upon conclusion of the lease.
It is customary for a seller to give the buyer a credit for the prepaid rent and the security deposits in a non-exchange sale of property. This causes no special issues. In a closing involving a 1031 tax deferred exchange, this same practice will result in taxable boot to the taxpayer. The way to avoid this outcome is for the seller/taxpayer to pay the amount of these credits directly to the buyer outside of the closing. Taxable boot may also result when the taxpayer acquires replacement property and receives credits. Again, those sums can be paid directly from the seller to the buyer in order to avoid any boot.