RELINQUISHED PROPERTY SUBJECT TO MORTGAGE

If the relinquished property is subject to a mortgage, then the replacement property should be subject to an equal or greater mortgage.  In an exchange, a reduction in debt may be offset with additional cash or “new money” from an outside source equal to or greater than the mortgage relieved on the relinquished property.  However, the taxpayer cannot reduce the equity in the property by offsetting it with an increase in debt.  At that point, net mortgage relief occurs and creates mortgage boot. 

When debt relief is present in a transaction, there will be a recognizable gain in the amount of the lesser of the gain on the disposition or the net mortgage relief.  In these instances when the gain on the disposition is greater than the net mortgage relief, partial tax-deferred treatment may be granted.  For example, a taxpayer sells property for $100,000, receives (in an Exchange Account) $50,000 in cash and $50,000 in debt relief.  The property has a $20,000 basis, thus creating an $80,000 potential gain from the sale.  The taxpayer then purchases a replacement property in an exchange for $100,000, but only reinvests $40,000 of the cash and acquires a new mortgage of $60,000.  The taxpayer receives $10,000 of exchange proceeds after the exchange, and realizes a capital gains tax event on the $10,000 received as boot.  The taxpayer may defer the taxes on the $40,000 of cash reinvested and $50,000 of the new mortgage, but will owe taxes on the $10,000 cash not reinvested.  If the net mortgage relief is greater than the gain, no tax deferral will occur.