What Is 1031 Exchange Boot?
We assume if you’re completing a 1031 exchange, you’re not interested in paying capital gains taxes with your next tax return. For a 1031 exchange to be entirely tax-free, you must not receive boot from the exchange. Unfortunately, any received boot is taxable, so if your goal is to avoid paying capital gains tax on the exchange, you may want to avoid boot.
If you are concerned about boot and want to know whether you will need to pay capital gains tax on your 1031 exchange, 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.
What Is Boot in Real Estate?
The old English term "boot" refers to "something that is given in addition to." Boot is the money received or the other property's fair market value received by the investor in an exchange. Money refers to all cash equivalents, along with the taxpayer's liabilities taken on by the other party. It is important to understand what items will be considered additional value or boot, because boot will cause a taxable event.
What Is Boot in a 1031 Exchange?
A 1031 exchange may be an option for reinvestment if you are an investor who wants to sell a real estate investment and defer tax payments on your capital gains. In a 1031 exchange, "boot" refers to additional value that is received when a replacement property is acquired. This portion of your received sales proceeds from a 1031 exchange is not reinvested. Boot can be created in different ways, including:
- Acquiring debt relief.
- Receiving cash.
- Adding personal property to a tax-deferred exchange.
For example, if you sell a property for $100,000 and reinvest only $80,000, the difference of $20,000 is referred to as boot. 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.
Though boot does not cancel your 1031 exchange, it may result in a large tax liability. Since you are likely conducting a 1031 exchange to defer payment of your capital gains tax, boot will counteract this benefit, as you will need to pay capital gains tax on the boot.
Types of Boot in Real Estate
Boot can result from several factors in a real estate investment exchange. Below are the most common types of boot in real estate.
Mortgage Boot or Debt Reduction Boot
Mortgage boot or debt reduction boot may occur when the replacement property's owed debt is less than the debt owed on your 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.
For instance, if your replacement property's mortgage is $100,000 and your relinquished property's mortgage is $120,000, then you will have $20,000 in debt reduction boot.
What is cash boot? 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 relinquished property's sale 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. At closing, if you use your sales proceeds for non-transaction costs, the outcome is the same as if you received cash due to the exchange and used the cash to cover these costs. Such services could include:
- Deposits for tenant damage transferred to the buyer.
- Utility escrow charges.
- Rent prorations.
- 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.
For example, if your replacement property and relinquished property each have a market value of $100,000, but the relinquished property has a $80,000 debt and your mortgage on the replacement property is $100,000, you'll have a taxable cash boot of $20,000 returned to you at the closing of the 1031 exchange. This is because you financed your replacement property in excess.
Non-Like-Kind or Personal Property Boot
Non-like-kind or personal property boot can occur when a replacement property's purchase includes personal property or non-like-kind items. This is a less common form of boot, but it is important to know that the following items are considered personal property rather than like-kind:
- Farm sprinkler equipment
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 greater or equal value than the value of 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 you receive from the relinquished property's sale.
Personal Residence Boot
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 purchase a property that has multiple units, you may not reside 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 greater than or equal to 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.
Like-Kind Exchange Boot
What is like-kind exchange boot? 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 rather than down.
The amount of the mortgage you take out to finance the replacement property should always be greater than or equal to the owed amount on the relinquished property. The replacement property's equity should always be greater than or equal to the amount of equity on the relinquished property.
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. The following are some offsets that may be allowed:
- Cash boot paid may offset debt reduction you receive.
- Cash boot paid may offset cash boot received at the same closing table.
- Debt you incur on your replacement property may offset debt reduction boot you receive on the property you relinquished.
Keep in mind that trading down will always result in boot received, so aim to trade across or up. It is best to consult your Qualified Intermediary to determine how to offset boot received.
Why Choose a 1031 Exchange?
The 1031 exchange process sticks to Section 1031 of the IRS code, allowing you to defer income tax payments on investment properties if you comply with specific conditions. If you sell an investment property, you can use your profits to buy another, similar property. You may consider a 1031 exchange if:
You want to increase your return potential: You can increase your purchasing power via a deferment of capital gains taxes, which can lead to greater returns on your replacement property.
You want to consolidate properties: If you no longer want to manage multiple holdings, you may want to exchange several property investments for a single piece of real estate. By consolidating properties, you'll more efficiently use your resources and time, putting your efforts into upkeep for a single property rather than multiple.
You want to restart property depreciation: By selling your current investment property and putting your profits into a new real estate investment, you may be able to reduce the potential depreciation you will need to recapture later.
If any of these is a reason you want to reinvest, you may build up your resources and save on tax payments with a 1031 exchange. Direct exchanges typically aren't tenable, but with our professional services at 1031 Crowdfunding, you can utilize our exchange syndication platform to successfully complete the process.
About Our 1031 Exchange Platform and How We Can Help
The process of a 1031 exchange can be complex, which makes understanding the guidelines challenging. With the right 1031 exchange services, however, the process can be more accessible and convenient. At 1031 Crowdfunding, we are experts with the experience and resources needed to handle the logistics of an exchange.
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At 1031 Crowdfunding, LLC, we're an online marketplace that facilitates 1031 exchange investments. We have more than six decades of combined experience in real estate and more than $2 billion in real estate transactions. Our inspired solutions empower our clients to invest with confidence. From private real estate funds to DSTs, our management team has the experience needed to navigate this burgeoning industry.