Mortgage Boot 1031 Exchange Guide
A 1031 exchange is an effective way to defer capital gains taxes on a replacement property when exchanging like-kind properties. A like-kind exchange is one in which investors exchange real properties that they hold as investments or use for business purposes. For example, a property owner can exchange an apartment building for an industrial building. Any like-kind property being exchanged in the United States must be exchanged with another property in the United States. While selling property in exchange for cheaper property may seem like an easy way to reduce debt and gain cash, it comes with a downside. Any excess cash or reduced debt you acquire during a real estate exchange is taxable, so property investors may owe money to the IRS unless they take the necessary steps to avoid mortgage boot. Mortgage boot on a 1031 exchange can cost property investors significant amounts of capital gains taxes. To defer said taxes, investors must completely replace the value of their original property.
Why Do I Owe Taxes on My 1031 Exchange?
If you conduct a 1031 exchange that doesn't replace the equity and debt of your relinquished property, you must pay capital gains taxes on the resulting 1031 mortgage boot. This boot will counteract your attempt to avoid tax payments with the 1031 exchange, so it's key to understand how to avoid mortgage boot. Both debt reduction and cash gains from a real estate exchange will cost taxpayers money because they are considered to be increased wealth, which is taxable income.
What Is Mortgage Boot?
The term "boot" is defined as "profit," or something received in addition. In real estate, boot is the money, or an acquired property's fair market value, that an investor receives during an exchange.
Mortgage boot is any additional value you receive when the replacement property's owed debt is less than the debt owed on your relinquished property. If you sell a property and your new replacement property doesn't replace the total value of your sold property, the additional value you receive and don't use is called boot, and it is taxable. For example, if your replacement property's mortgage is $110,000 and your relinquished property's mortgage is $120,000, then you will have $10,000 in mortgage boot.
The IRS taxes boot at a taxpayer's regular tax rates, and taxpayers report it on line 15 of Form 8824, which covers like-kind exchanges.
How Did Boot Originate?
The word "boot" in real estate comes from an English term for "something that is given in addition to." These are any gains that a property investor acquires during a real estate exchange — they can receive boot when they receive cash, acquire debt relief or add personal property to a tax-deferred exchange.
The following sources can result in boot:
- Cash: Net cash flow is the money that remains after a property investor sells their property and purchases a new property.
- Reduced debt: Property investors acquire reduced debt when they "trade" their relinquished property for a cheaper property. This means that the debt they owe on their replacement property is less than the debt they previously owed on their relinquished property. This is considered an advantage because they receive debt relief from their exchange. The debt relief reduces what they owe, which counts as taxable income. The debt on the new property must be equal to or greater than the debt on the relinquished property.
- Sale proceeds: When a property investor receives proceeds after selling relinquished property and uses these proceeds to cover non-closing expenses during the relinquished property or the replacement property's closing, tax collectors consider it equivalent to cash received. Non-closing costs can include rent prorations, property tax prorations, tenant damage deposits and any other expenses unrelated to closing costs. The exchanger can never receive the money themselves. It must go through a Qualified Intermediary. Otherwise, the exchange will be disqualified.
- Excess borrowing: 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. This is because the investor will receive the excess cash that isn't needed to cover the new property, which makes it added value that can be taxed.
- Personal property: A property investor may relinquish a property for $500,000 and use that sale to purchase a $500,000 replacement property, which would not acquire a boot and remain a tax-free exchange. However, if the investor's replacement property comes with any personal property, it is considered increased wealth. This is because the personal property does not count as like-kind real estate. For example, if $100,00 worth of machinery or furniture is part of a sale, only $400,000 will be included in the exchange, and $100,000 would be taxed.
Mortgage Boot/Debt Reduction Boot Example
Imagine you own a property and sell it for $350,000, and you still owe a $120,000 remaining balance on your mortgage. After you sell the property, you will use the received money to send $120,000 to your mortgage lender to pay off your remaining debt. Afterward, you will have $230,000 left from the sale of your relinquished property, minus any closing costs.
To complete a 1031 exchange, you will need to purchase a new like-kind property with a value that is equal to or more than the $230,000, minus closing costs, in addition to the $120,000 that you used to pay off your previous debt. If you only spend $230,000 on your replacement property, the $120,000 is considered capital gains and counts as a boot. This is because when your debt is reduced, you receive an additional value that counts as increased income, which is taxable.
How to Avoid Mortgage Boot Using the Debt Replacement Principle
To complete a completely tax-free 1031 exchange, you must avoid receiving a boot with a 1031 exchange debt replacement. To do this, you must replace the debt of your relinquished property when you complete your exchange. Situations that would not receive a boot include the following:1. Trade Across or Up
You can avoid a mortgage boot by trading across or trading up when you make a 1031 exchange. This means that you purchase a replacement property including debt that equals or costs more than the cost of your previous mortgage. Either way, you need to reinvest the total amount you receive from the relinquished property into your new property.2. Pay Extra on Your Replacement Property
If your replacement property mortgage is less than the amount of your previous mortgage, you can consider putting up additional funds to make up for your mortgage. If you do this, it will allow you to avoid paying capital gains taxes. Some investors choose this method because they expect market appreciation to increase. While market values fluctuate, they are unpredictable, so this method of debt replacement may not be the most beneficial choice.3. Purchase Two Replacement Properties
Another way to avoid paying taxes due to mortgage boot is to purchase two replacement properties with a loan amount that is equal or greater than your relinquished property. By purchasing two replacement properties, it may be easier to acquire a mortgage that meets 1031 exchange requirements. Purchasing two properties may cost you more in up-front costs, but over time, it can prove to be a beneficial investment.4. Refinance
You can choose to refinance your replacement property before or after a 1031 exchange, but refinancing after the exchange is usually less risky. Refinancing a property before the exchange means that you take cash out, so you end up with less cash, more debt on your replacement property and debt paid off on your relinquished property after the exchange. Still, the IRS will likely challenge this exchange, unless you have business purposes for the refinance that are independent of the anticipated exchange.
Business purposes for a pre-exchange refinance could include draining cash from damaged buildings, cash-flow issues or other business-related problems. The IRS is less likely to challenge a refinance completed for these purposes. Without business purposes, the IRS may tax withdrawn cash or consider the exchange abusive. The IRS accepts post-exchange refinances because investors have to repay the replacement property's outstanding debt, which means there is no wealth increase or taxpayer gain.
Another Example of How to Avoid a Mortgage Boot
To avoid mortgage boot, you must replace the debt value of your relinquished property. For example, if you sell a vacation condo for $900,000, you have to consider its equity and the debt. Let's say you have a $500,000 loan and $400,000 equity. To avoid taxes with a 1031 exchange, you will have to apply your $400,000 equity to your replacement property and replace your loan's $500,000 debt.
There are various ways you can do this. The simplest way would be to purchase a new property valued at $900,000. If the replacement property costs less, you will have to use a different method to replace your relinquished property's value. For example, maybe the new property costs $800,000, leaving you with a potential $100,000 boot. You could offer additional funds to make up for the $100,000.
You could also purchase a replacement property that costs more than your relinquished property or purchase two properties, as long as the debt is equal or greater than the previous debt. For example, you could purchase a $950,000 vacation condo or two smaller condos for $500,000 each.
1031 Exchange Rules
1031 exchanges have a time limit. The IRS requires property investors to purchase their replacement property within 180 days of beginning the exchange. Once they begin the exchange, they must identify their potential replacement property within 45 days, which is included in the full 180-day time limit. Investors must use this time wisely to research and find a replacement property that meets the required criteria, so it's important to have a plan before beginning an exchange.
For a successful exchange, investors must remember the following rules:
- Identify the replacement property on time: The IRS requires investors to submit clear, written descriptions of their potential replacement properties by midnight on the 45th day of the exchange process. Include the property's exact address and unit numbers. This ensures that the IRS can confirm that your replacement property matches your relinquished property and meets relevant criteria.
- Follow the three-property rule and the 200% rule: You can submit descriptions of up to three properties if you're planning to purchase at least one of them. This is known as the three-property rule. If you choose to submit more than three properties, you must follow the 200% rule and make sure their combined value is less than 200% of the relinquished property's market value.
- Know the rule exceptions: There are exceptions to the three-property rule and the 200% rule. If your selected properties fail to meet the three-property and 200% rule criteria, you must acquire 95% of your new holdings' combined market value.
- Leave room to change your mind: The earlier you submit your potential replacement properties, the more time you will have to submit changes if you decide on a different property. You can change your mind and submit a new property in writing as long as you do so within the 45-day time limit.
An experienced professional can guide you through the process to make it as easy as possible. Join the crowd at 1031 Crowdfunding and let our expert team navigate the 1031 process quickly and efficiently.
Browse Eligible 1031 Properties With 1031 Crowdfunding
1031 exchanges are meant to help property investors avoid paying capital gains taxes when they exchange properties. A mortgage boot can counteract a 1031 exchange, so it's important to understand how to avoid potential boot. If you purchase a property with a lower value than your relinquished property, you could end up owing money to the IRS for capital gains taxes.
The IRS considers any exchange that replaces the value of a relinquished property tax-free, so it's important to replace the equity and the debt of your sold property. Replacing debt is simple when you work with the experts. At 1031 Crowdfunding, we offer investments with various loan-to-values so that your replacement debt is enough to ensure a tax-free exchange. We can walk you through the process to complete your exchange while avoiding potential tax risks.
Browse our marketplace of 1031 eligible investment properties to find a replacement property that meets your needs. We will provide all of the necessary documents and work through the details with you to complete your exchange efficiently and quickly. Avoid closing risks by choosing from our pre-purchased properties and enjoy the convenience of closing in as little as three to five days.
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