“Why do I owe taxes on the property I sold when I completed a 1031 exchange with the purchase of a new property?” This is a question that is far too common by 1031 exchangers. The usual answer is: Boot.
Boot is an old English term that means “Something given in addition to.” In a 1031 exchange, boot is a common term for additional value received when acquiring a replacement property in a 1031 exchange. In other words, when the complete value of your relinquished property is not replaced by eligible replacement property, the unused value is called boot. And the value of the boot will be taxed as capital gains.
There are many forms of boot that we described in an earlier blog titled What is Boot and How to Avoid It? If you’re considering a 1031 exchange and are not familiar boot, we recommend that you take another look at the various types of boot to ensure you don’t fall into any of these unfortunate 1031 exchange mistakes that will cost you.
One of the more common types of boot that investors get taxed for is Mortgage Boot, also known as Debt Reduction Boot. Mortgage boot occurs when the debt owed on the replacement property is less than the debt that was owed on the relinquished property at the time of sale.
For example: Let’s say you plan to sell a property for $450,000. The mortgage on the property has a remaining balance of $100,000. After selling the property, you will pay-off the debt by sending $100,000 to the mortgage lender. That would leave you with $350,000 remaining cash (less closing costs, of course) to pocket. If you decide to complete a 1031 exchange, you would need to purchase a property that would require the use the $350,000 (less closing costs) cash that you received from the sale and at least $100,000 from a new mortgage or additional cash contribution. If the acquisition of your replacement property only costs you the $350,000 cash from the sale of your property, you would be taxed on capital gains of $100,000.
Debt reduction in a 1031 exchange is considered boot because additional value is received by you, the investor, rather than putting the entire value of the relinquished property into the replacement property. Reducing your debt liability, in effect, is an increase in income, which is taxable. 1031 exchanges defer taxes on such income only if it is reinvested into a replacement property.
Mortgage boot can be avoided by following the Debt Replacement Principle, a safeguard to help you identify whether or not you’ve completed a qualifying exchange. The debt reduction principle states that the acquisition of a replacement property must require the investor to either take out a new mortgage that is equal to or greater than the amount owed on the relinquished property at the time of sale or elect to replace the previous amount of debt with an additional cash contribution.
For example: Consider the above example where you paid off a $100,000 mortgage after the sale of the relinquished property. To follow the debt reduction principle, you must either: 1) Obtain a new mortgage in the amount of at least $100,000, 2) Contribute at least $100,000 in cash, or 3) Apply some combination of financing and cash that amounts to $100,000 or more for the acquisition of the replacement property.
Next week we’ll talk about how you can follow the debt replacement principle and avoid mortgage boot when you invest in a Delaware Statutory Trust.