Like Kind Exchange--How to handle prorated rent?

Client sells real estate having a FMV of 1,000,000. No debt, basis is 0. Property is sold for 1,000,000; proceeds go to QI. Client records JE:

DR exchange proceeds 1,000,000
DR building 500,000
CR deferred gain 1,000,000
CR A/D 500,000.

Client buys new building with FMV of 1,000,000. No debt is involved here, but the closing statement shows a credit for prorated rents of $50k; so the client essentially only has to pay 950,000 for the replacement property.

What should the next JE look like?

DR cash (checking account) 50,000
DR deferred gain 1,000,000
CR exchange proceeds 1,000,000
CR gain? revenue? 50,000

I'm thinking revenue, but not sure how that is going to work out on Form 8824.

Help please?! (First post--hi everyone!)

Your JE appears correct, but you've misstated facts.

The new property didn't have a FMV of $1M. It has a FMV of $950K. The remaining $50K your client purchased was rental income. You don't treat this as boot, but as a purchase of NON-like-kind property.

You don't treat this as boot, but as a purchase of NON-like-kind property.

It's not "NON-like-kind property." It's money. The $50,000 is taxable as “boot” since it is money received in the exchange. See Sec. 1031(b).

Edit Note: See #7 below.

I'll admit I'm not a 1031 expert, but here's how I read the OP.
The purchaser paid $50K to receive an asset. This asset was not like-kind.

I see the error of my initial thinking...here's the correct JE based on correcting my error:

DR cash (checking account) 50,000
DR building 950,000
CR exchange proceeds 1,000,000

It IS boot because it is cash as Dave points out.

Am I thinking wrong, or would you not have a gain of $50,000 from the first transaction because you only bought a building for $950,000 and, assuming an accrual taxpayer, have a $50,000 entry for prepaid rent?

The agreed value of the building acquired is 1,000 (dropping 3 zeroes). As of the date he acquires it, he only "pays" 950. That's to "compensate" him for the 50 in rent he should get but the seller got.

There is no doubt that client has income. Think of a straight cash deal, price 1,000, less prorated rent 50, cash paid by buyer 950. In effect, seller has paid buyer 50 in rent. Buyer's entry:
dr property. 1,000
cr cash. 950
cr income. 50

Now, is it rent or boot when we deal with 1031? Here is what one intermediary says,

Security deposits, repair costs and prepaid rent that are allocated among buyer and seller in a purchase and sale contract through a standard prorations clause, can be another source of taxable boot if not handled carefully. The prorations clause works by adjusting the amount of cash that must be paid by the buyer at closing. For example, a typical rent proration clause would credit the buyer with rents already received by the seller that are allocable to the period following the closing thereby reducing the amount of cash the buyer must deposit. Such a clause generates boot as the seller has, in effect, treated the prorated amount allocated to the buyer as part of the buyer’s consideration for the property. At closing, this cash is in the seller’s hands and does not pass to seller’s qualified intermediary to be used in the exchange. This is boot, plain and simple. That result could be avoided by having the seller deposit the prorated rents into escrow before the closing.

. https://apiexchange.com/materials/1031-tax-handbook.pdf. Are they right?
Your client surely did not receive any boot, did he? He received the property and 50 in prepaid rent (which is always taxable when received).
P.S. Go back to OP's first entry, for the property given up. I think part of it is backwards.

I agree with Nilodop that there’s something wrong with the numbers here. If the relinquished property was sold for $1,000,000, and $950,000 of the proceeds went to purchase the replacement property, then $50,000 of the proceeds went somewhere else. Where? To the client? If the client received a $50,000 CREDIT for prorated rent on the closing statement for the purchase of the replacement property, then isn’t this rental income, not “boot”?

From the facts presented, it looks like the client has a $50,000 gain on the exchange by virtue of not investing all of the proceeds into the replacement property (maybe the client received $50,000 cash), and also $50,000 of rental income. You need to scrutinize the closing statements and the funds ledger from the intermediary to see where all of the money went. You have to account for every penny. There are all kinds of closing costs and exchange expenses to account for.

https://www.ipx1031.com/closing-costs-a ... -exchange/

The agreed value of the building acquired is 1,000 (dropping 3 zeroes). As of the date he acquires it, he only "pays" 950. That's to "compensate" him for the 50 in rent he should get but the seller got.

There is no doubt that client has income. Think of a straight cash deal, price 1,000, less prorated rent 50, cash paid by buyer 950. In effect, seller has paid buyer 50 in rent. Buyer's entry:
dr property. 1,000
cr cash. 950
cr income. 50

Now, is it rent or boot when we deal with 1031? Here is what one intermediary says,

Security deposits, repair costs and prepaid rent that are allocated among buyer and seller in a purchase and sale contract through a standard prorations clause, can be another source of taxable boot if not handled carefully. The prorations clause works by adjusting the amount of cash that must be paid by the buyer at closing. For example, a typical rent proration clause would credit the buyer with rents already received by the seller that are allocable to the period following the closing thereby reducing the amount of cash the buyer must deposit. Such a clause generates boot as the seller has, in effect, treated the prorated amount allocated to the buyer as part of the buyer’s consideration for the property. At closing, this cash is in the seller’s hands and does not pass to seller’s qualified intermediary to be used in the exchange. This is boot, plain and simple. That result could be avoided by having the seller deposit the prorated rents into escrow before the closing.

. https://apiexchange.com/materials/1031-tax-handbook.pdf. Are they right?
Your client surely did not receive any boot, did he? He received the property and 50 in prepaid rent (which is always taxable when received).
P.S. Go back to OP's first entry, for the property given up. I think part of it is backwards.

My first entry is partially backwards. The A/D should be debited and the building credited. Oops; thanks.

I agree with Nilodop that there’s something wrong with the numbers here. If the relinquished property was sold for $1,000,000, and $950,000 of the proceeds went to purchase the replacement property, then $50,000 of the proceeds went somewhere else. Where? To the client? If the client received a $50,000 CREDIT for prorated rent on the closing statement for the purchase of the replacement property, then isn’t this rental income, not “boot”?

From the facts presented, it looks like the client has a $50,000 gain on the exchange by virtue of not investing all of the proceeds into the replacement property (maybe the client received $50,000 cash), and also $50,000 of rental income. You need to scrutinize the closing statements and the funds ledger from the intermediary to see where all of the money went. You have to account for every penny. There are all kinds of closing costs and exchange expenses to account for.

Dave--

"Where? To the client?" -- In my example, yes, the client would receive the $50k back from the QI. However, does this need to be treated as both gain and revenue? I don't know, but maybe the JE for the purchase should look like:

DR Building 50,000
DR cash (checking account) 50,000
DR deferred gain 1,000,000
CR exchange proceeds 1,000,000
CR gain 50,000
CR rental income 50,000


Consider a second example: Same relinquished property situation, but on the purchase the client buys a building with a FMV of 2,000,000, with a 1,000,000 credit for prorated rent. So it only really costs the client 1,000,000.

DR deferred gain 1,000,000
CR exchange proceeds 1,000,000
CR rent revenue 1,000,000

We're missing a 1,000,000 debit. Has to go to building right?

Dave--

"Where? To the client?" -- In my example, yes, the client would receive the $50k back from the QI. However, does this need to be treated as both gain and revenue? I don't know, but maybe the JE for the purchase should look like:

DR Building 50,000
DR cash (checking account) 50,000
DR deferred gain 1,000,000
CR exchange proceeds 1,000,000
CR gain 50,000
CR rental income 50,000

Consider a second example: Same relinquished property situation, but on the purchase the client buys a building with a FMV of 2,000,000, with a 1,000,000 credit for prorated rent. So it only really costs the client 1,000,000.

DR deferred gain 1,000,000
CR exchange proceeds 1,000,000
CR rent revenue 1,000,000

We're missing a 1,000,000 debit. Has to go to building right?

Are you asking a tax question or an accounting question? If you are asking a tax question, then you shouldn't get hung up on journal entries.

Here are the facts you provided:

Relinquished Property
Sales price - $1,000,000
Proceeds - $1,000,000 to QI

Replacement Property
Purchase price - $1,000,000
Funded with proceeds from QI - $950,000
Funded with credit for prorated rents - $50,000

According to these facts, the QI still has $50,000 of exchange funds from the sale of the relinquished property that haven’t been spent. This is $50,000 of “boot” which is taxed unless the $50,000 was spent on exchange expenses or other like-kind property.

The $50,000 in prorated rents is rental income received outside of the exchange and must be reported as income on the return.

Thus, $50,000 in gain on the exchange, and $50,000 in rental income.

If you are asking a tax question, then you shouldn't get hung up on journal entries.. Well, maybe they are not required by law, but they can sure help in determining tax basis and whether you are reporting the right amount of income.

Well, maybe they are not required by law, but they can sure help in determining tax basis and whether you are reporting the right amount of income.

And they can also confuse the situation so that you end up reaching the wrong conclusion for tax purposes.

Thus, $50,000 in gain on the exchange, and $50,000 in rental income.

That doesn't sound correct. We need journal entries, here, to see if we have 2 CR's for $50K.

What if the buyer put $50K out of his own pocket as a deposit towards the purchase and then got the $50K back later from the QI. Is there $50K of boot? I propose that is what has happened here. Seller gives buyer $50K of prorated rent. Buyer deposits that into the exchange.

There is $50K of rental income. No capital gain.

I propose that is essentially what has happened here.

Agreed. I think you’re saying the guy basically got $50k of rental income (taxable) and effectively kicked it back into the deal, as cash boot paid, which offsets the cash boot received (i.e. remaining funds held by the QI that will go back to the taxpayer).

I use journal entries with these things, but not like OP does. I spreadsheet out the closing statements in a single column. Then I break them down into debit and credits (2 columns), only for balancing purposes. (I have a separate section for tracking/accounting for the QI funds). I add rows for things that happened outside of closing. Once all of that is in place, I add columns to summarize Exchange Expenses and Non-exchange Expenses. All of this input directly feeds into my 1031 calculator. And then the journal entry(ies) is spit out at the end.

What if the buyer put $50K out of his own pocket as a deposit towards the purchase and then got the $50K back later from the QI. Is there $50K of boot? I propose that is what has happened here. Seller gives buyer $50K of prorated rent. Buyer deposits that into the exchange.

Then OP should tell us that's what happened. The facts OP has given us are oversimplified and leave out a lot of detail.

How about we accept facts given by OP.
Each property valued at 1000. Precisely.
No debt.
We only care about OP's client's tax aspects.
OP's client received cash from other party to pay OP's client for rents that other party collected but belong to OP's client.
Economically, it is clear that OP's client received a total of 1050, consisting of a 1000 value, but zero basis, property, and rent of 50.
To my knowledge, the tax law in an exchange, even one with a QI, does not tax more than economic income. If we say there is taxable boot of 50 and rent of 50, we are taxing 50 more than economic income.
OP's client won't like that, and he won't even get it back in tax basis, right? Isn't his basis zero (old basis) plus 50 boot recognized as gain (if there is boot) less 50 cash (the boot), for a total of zero?
Conclusion, no boot, rental income 50.
And for the heck of it, other party reduces his rent oncome by 50.

Where did the half-million dollars of accumulated depreciation in the OP come from, and where did it go to?

Any assertion that using double entry accounting for income tax purposes is confusing confirms only that the alleger didn't understand the accounting.

Any assertion that using double entry accounting for income tax purposes is confusing confirms only that the alleger didn't understand the accounting.

I understand double-entry accounting just perfectly. What I don't understand is this: If the relinquished property was sold for $1,000,000, and all the proceeds went to the QI, and the QI used $950,000 of those proceeds to purchase the replacement property, where did the remaining $50,000 go? The double-entry accounting entries don't answer this question.