'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.
When we discuss the term ‘boot’ in regards to 1031 exchanges, we’re not talking about footwear; however, we’re also not talking about a term found in IRS Code 1031. It is important to understand what items will be considered additional value, or boot because boot will cause a taxable event. We assume if you’re completing a 1031 exchange, you’re not interested in paying capital gains taxes with your next tax return. Let us take a few minutes of your time to help explain boot so you’re not surprised at the end of your fiscal year.
The IRS code requires that a like-kind property must be acquired to replace a relinquished property. A rule of thumb to remember to avoid a tax bill is to trade across or up, never down. The amount of the mortgage you take out to finance your replacement property should always be equal to or greater than the amount owed on the relinquished property. The amount of equity held on the replacement property should always be equal to or greater than the amount of equity held on the relinquished property.
Types of Boot
Mortgage Boot or Debt Reduction Boot occurs when the debt owed on the replacement property is less than the debt that was owed on the relinquished property. Reducing your debt liability is considered income because it is cash that you once owed that will now remain in your pocket at the time the debt matures. Income, as you know, is taxable.
Cash Boot occurs in several ways. One of the most obvious ways you can acquire cash boot is to have a net cash received amount. When the cash received from the sale of the relinquished property is greater than the cash paid to purchase the replacement property, you will have a net cash received amount that will be considered income, and again, income is taxable. Another way you can accumulate cash boot is to have a promissory note incorporated into the exchange. Cash boot would also include the use of interest earned on the sale proceeds while they were held before being used in the acquisition of the replacement property. Furthermore, in some cases, the seller of the replacement property may pay for repairs that you, as the buyer, have required. The value of these repairs will also be considered cash boot.
Sale Proceeds can result as boot if they are used to pay non-qualified expenses, such as service costs at closing that are not considered closing costs. Such services could include rent prorations, utility escrow charges, tenant damage deposits transferred to the buyer, and any other charges unrelated to the closing. To avoid turning your sale proceeds into boot, pay for such items using cash out of your pocket.
Excess Borrowing can result as boot if you borrow more money than you need to purchase the replacement property. If the loan amount is too great, you will not be able to use all of your exchange funds to purchase the replacement property and will be taxed on any funds remaining.
Non-Like-Kind or Personal Property Boot occurs when the purchase of a replacement property includes non-like-kind or personal property items. This is a less common form of boot, but it is important to know that items such as appliances, furniture, farm sprinkler equipment, fixtures, etc. are considered personal property rather than like-kind. If the replacement property purchase includes personal items, the value of the like-kind property alone is less than the purchase price for the like-kind property in addition to the personal property items. You will be taxed on the value of the personal property items obtained with the replacement property if the like-kind property on its own is not of equal or greater value than the relinquished property. The best way to avoid personal property boot is to clearly state in the selling contract that the listed personal property items are excluded from the sale. You can purchase these items separately with a separate sale agreement, using cash out of your pocket rather than cash received from the sale of the relinquished property.
Personal Residence Boot is another less common form of boot that occurs when you choose to use a part of the replacement property as a personal residence. For example, if you acquire a property with multiple units, you cannot live in one of them. You will be taxed on the value of the portion of the property in which you choose to reside if the value of the remainder of the property is not equal to or greater than the value of the relinquished property.
Be sure to discuss all items included in the sale of your relinquished property and the acquisition of your replacement property with your Qualified Intermediary. Your Qualified Intermediary should be your source to help ensure you have not accumulated any of these forms of boot whether intentionally or inadvertently.
Boot received can be offset by boot paid. Only your net boot will be taxable, so even if you do encounter boot in your transactions, you may be able to offset it and continue your total tax-deferred transaction. It is best to consult your Qualified Intermediary to determine how to offset boot received. Next week we will show you how to "put your boot to work."
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.