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Avoiding Taxes and Mortgage Boot Using the Debt Replacement Principle

“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 other words, when the complete value of your relinquished property is not replaced by eligible replacement property, the unused value is called boot. The value of the boot will then be taxed as capital gains.

If you’re considering a 1031 exchange and are not familiar with 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 of the $350,000 cash (less closing costs) 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.

What is the Debt Replacement Principle

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 replacement 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 replacement 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 by investing into Delaware Statutory Trusts.

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This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements are speculative in nature and involve a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC, member FINRA, SIPC.