Don't settle for paying taxes on your 1031 exchange boot; put your boot to work.
Let us explain. Imagine you’ve made a $200,000 profit on the sale of your relinquished property, but your replacement property will only cost $150,000 to acquire. The remaining $50,000 is considered boot and will become taxable unless you find a way to eliminate it. You could look for a second replacement property to acquire, but you may not have enough time within your 45-day identification period. Likewise, $50,000 may not be enough to purchase a worthwhile investment property, and you probably aren’t interested in investing additional funds out of your pocket in order to afford a property you would consider worthwhile. So you might consider accepting the tax consequences.
But wait! We have a solution.
Use the excess cash to acquire beneficial interests in a Delaware Statutory Trust (“DST”). With a DST, you choose the amount you wish to invest. You can invest the exact amount necessary to avoid incurring a 1031 exchange boot – not a penny more, not a penny less than you have allocated for your replacement property. Why pay taxes on excess cash when you can invest it and let it earn you additional income?
Leverage your income.
Say you don’t take our advice. You pocket the excess cash and pay the taxes. Now, what do you do with the cash? You’re probably not going to let it sit in a zero to low-interest paying bank account. If you’re going to invest it anyway, wouldn’t it be better to invest the total amount pre-tax rather than the after-tax amount? You can leverage the income you’ve already earned to produce greater amounts of future income when you defer taxes and re-invest your pre-tax cash.
What about Diversification?
Perhaps you’re thinking paying tax on a small amount of boot is a small price to pay for an opportunity to liquidate some of your real estate investments and diversify your portfolio. May we suggest that diversification among your real estate portfolio can potentially have the same risk-reducing effect? When you complete your 1031 exchange by acquiring a replacement property, you are limiting your dependence on a single property to meet your investment goals. When you invest your excess cash into a DST, you can afford to purchase a percentage of investment-grade real estate. You can diversify your real estate portfolio and offer a second opportunity to earn income if the primary investment property does not produce as expected.
Have a backup plan.
Don’t be surprised by boot as you near the end of your exchange transactions. Plan ahead and put a backup plan in place. If you identify a property within a DST as one of your three replacement properties, you are covered in the event that you have boot in the form of excess cash after the acquisition of your replacement property. The excess cash can be invested in the DST, and your taxable boot is eliminated.
While the information provided above has been researched and is thought to be reasonable and accurate, it’s important to talk with your tax professional regarding your personal tax situation.