1031 exchanges allow investors to defer capital gains tax on the proceeds from the sale of their investment properties. If you’re completing a 1031 exchange, you must reinvest all your profits into your replacement property for it to be completely tax-free. If you don’t reinvest the entire amount, the amount left over is immediately taxable. This leftover amount is called boot. You can also provoke boot by receiving cash, acquiring any non-like-kind property, or assuming a lower mortgage on the replacement property than the mortgage of the relinquished property without contributing additional cash.
While incurring boot does not disqualify your 1031 exchange, you’ll want to avoid it to reap the full benefits of this real estate investment strategy and prevent a significant tax liability. This 1031 exchange boot guide explains everything you need to know about real estate boot, how it happens, and how you can avoid it.
Read the full article or skip to a specific section:
- What Does Boot Mean?
- What Is Boot in a 1031 Exchange?
- How 1031 Exchange Boot Happens
- Examples of Boot
- How to Calculate Boot
- How Boot Is Taxed
- How to Avoid Boot in a 1031 Exchange
- Putting Your Boot to Work
What Does Boot Mean?
The old English term “boot” refers to “something that is given in addition to.” Boot in real estate is the non-like-kind property you receive in a 1031 exchange, which is generally in the form of cash or an installment note. However, boot can come in many forms, including mortgage reduction, where your replacement property has a smaller mortgage than your relinquished property, and non-transaction costs, where you use sales proceeds from your exchange to pay certain expenses.
The money you receive as “boot” in an exchange 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?
Boot is any portion of the proceeds from a 1031 exchange that you do not reinvest in a replacement property. For instance, if you sell a property for $500,000 but only reinvest $425,000, your $75,000 left over is boot. The purpose of performing a 1031 exchange is to defer capital gains tax, but if you receive boot, you essentially lose this benefit because those funds are subject to taxation. You will be taxed on the $75,000 since it wasn’t put toward another investment property.
Boot is a commonly used term when it comes to a 1031 tax-deferred exchange because it refers to anything that you receive that is non-like-kind property. While this is most often in the form of cash, it can also be an installment note or property you buy with the $75,000, for example. Rather than having a fully tax-deferred exchange, you will have a partially tax-deferred exchange.
Other examples of boot include:
- Property intended for personal use
- Real property exchanged for personal property
- Cash proceeds remaining after the exchange ends
- Cash proceeds received after closing on the replacement property
- Non-qualified property, such as bonds, stocks, or partnership interests
- Cash proceeds taken before being sent to the Qualified Intermediary (QI)
- Relief from debt through the assumption of a mortgage that is less than the relinquished property’s debt
How Boot in a 1031 Exchange Happens
We briefly mentioned how boot could occur, but let’s expand on those scenarios so you can fully understand this process. You can create boot intentionally or by accident, so it’s important to know exactly how these situations can come about to avoid an unpleasant surprise when it’s time to do your taxes.
Cash boot received during the 1031 exchange will be taxed. These funds are generally referred to as “net cash received” once you close on your relinquished or replacement property. This means the cash you received from your relinquished property is greater than the amount of cash you paid to purchase the replacement property, and the difference is considered income. You can receive this cash by failing to transfer 100% of your relinquished property sales proceeds to your QI while you identify and close on your replacement property.
Cash proceeds will also occur if you do not use 100% of the relinquished property sales proceeds to purchase your replacement property. This situation happens when you do not fully roll over your proceeds into the next investment and get cash returned to you when you complete the 1031 exchange.
Other ways you can accumulate cash proceeds boot include a promissory note in your 1031 exchange, interest earned on the sale proceeds while they are being held during the process of acquiring a replacement property, or the value of repairs you require the seller of the replacement property to pay for.
In some cases, excess borrowing used to acquire the replacement property may also be taxed as cash boot. If you borrow more money than is necessary for your 1031 exchange replacement property, your QI will hold excessive cash for closing, which they will distribute to you when the process is complete. To defer capital gains tax, investors must use all cash being held by the QI for the replacement property.
Mortgage boot, also called debt reduction boot, usually occurs when you buy a replacement property with a smaller mortgage than your relinquished property. Since you are essentially trading a higher-priced loan for a less expensive loan after your 1031 exchange, you can create taxable boot, even if you don’t receive any cash back. This situation is also referred to as debt reduction boot because it means the debt you owe on the replacement property is less than the debt you owed on the relinquished property at the time of sale.
For instance, if the mortgage on a 1031 exchange property is only $80,000 while the mortgage on your relinquished property was $100,000, then $20,000 is your debt reduction. This debt reduction can be taxed as income, even if 100% of your sales proceeds rolled over toward your new investment property.
This process is also known as trading down since your debt on the new property is less than what it was on your previous one. Remember that mortgage boot can also develop if you over-finance your replacement property mortgage, even if the two properties are of the same value.
Any sales proceeds from a 1031 exchange that an investor uses for non-transaction costs, including non-closing expenses, will result in taxable boot. Using sale proceeds to service these costs is the same as if the investor received cash from the 1031 exchange and used those funds to pay these costs. Some of these costs include:
- Legal fees
- Escrow fees
- Brokerage fees
- Tenant buy-out
- Rent prorations
- Code violations
- Association fees
- Hazard insurance
- Utility service charges
- Property tax prorations
- Credits for lease deposits
- Inspection and appraisal fees
- Pro-rated mortgage insurance
- Any other expenses unrelated to the closing
- Tenant security deposits transferred to the buyer
- Outstanding bills for property management services, maintenance, or repairs
The Internal Revenue Service (IRS) will tax anything that falls within the above categories, so investors need to bring extra funds outside of the exchange to the closing to pay for these costs.
Another way to develop taxable boot is by including any property that is not like-kind in your 1031 exchange. The IRS defines a like-kind property as a property of the same nature that serves the same purpose as the relinquished property, even if they aren’t the same grade or quality. Any building used as an investment property is generally considered like-kind to another property purchased for investment purposes. For example, a multi-family residential building would be considered like-kind to an office building or a shopping center.
However, if the investor receives additional property from the exchange along with the like-kind real estate — known as personal property — it could create boot. Some examples of these personal items include:
- Seller financing
- Promissory notes
- Real estate partnership interest
- Stock acquired after buying farmland
- Sprinkler equipment acquired with farmland
Though non-like-kind property is sometimes referred to as non-qualified property or personal property, the terms are not interchangeable. If any personal items are included in the 1031 exchange, you will be taxed on their value if the like-kind property alone is not of greater or equal value than the relinquished property.
Including personal property or non-like-kind property in an exchange can happen accidentally, so it’s important to clearly state which items are included and excluded from the sale to avoid boot. While you can still purchase these items in a separate sale agreement, it’s essential to use your own funds rather than the sale proceeds of the relinquished property. Or, you can work with the seller on the purchase contract to ensure any of these extra items are included in the sale price of the real estate.
The most critical aspect of a like-kind property for a 1031 exchange is how the investor intends to use it. If the investor plans to do a 1031 exchange and use the property for business or investment purposes, then it is generally considered like-kind. However, if the investor intends to use their replacement property for personal use, such as a second home, this would not be considered an investment that is eligible for deferring capital gains tax.
Personal residence boot can also occur if you buy an apartment building and decide to reside in one of the units. Since that would be considered your personal residence and not an investment, you would be taxed on the value of the portion of the property you reside in if it is not equal to or greater than the value of your relinquished property. While personal residence is a less common type of boot, it’s necessary to keep it in mind before performing a 1031 exchange.
Examples of Boot
If you’re thinking about performing a 1031 exchange or are in the early stages of the process, be sure to consider what scenarios might create boot so you can prevent getting taxed on sales proceeds or other forms of cash that will be considered income. If you’re confused about how a 1031 exchange works with a mortgage or leftover cash, here are some different examples to consider.
In this first example, imagine you sell a property for $500,000 — $100,000 more than you initially paid — with $20,000 in closing costs. Your capital gain from the sale would be $80,000. As part of your 1031 exchange, you identify and purchase a replacement property worth $450,000 with $15,000 in closing costs, which creates a net value of $465,000.
Since you relinquished the first property for $480,000 — $500,000 minus $20,000 closing costs — this leaves a difference of $15,000 between your relinquished property and your replacement 1031 exchange property. After the exchange, you would receive the leftover $15,000 as cash. The IRS would tax this $15,000 as income, so you can only defer taxes on the $65,000 of your original $80,000 capital gains.
As a second example, imagine you decide to relinquish a property worth $900,000. Instead of finding a property of equal or greater value to receive 100% tax deferral, you choose a replacement property valued at $800,000. Let’s say closing costs are $50,000. This would leave you with another $50,000 left over as cash after closing.
Instead of putting all the proceeds into a 1031 exchange escrow account, you keep the $50,000 and deposit it into your checking account to pay off your credit card debt and other bills. This leaves you with a partial tax deferral. The IRS sees this $50,000 as value received from your 1031 exchange and will tax these funds because they did not contribute to the 1031 exchange.
Even on smaller amounts, such as if you pay off the mortgage on your property with a value of $100,000 and purchase a replacement property valued at $90,000, the $10,000 you receive as cash will be considered cash boot.
Imagine you sell your property for $650,000 with $250,000 remaining on your mortgage. Once you use the 1031 exchange to pay off the mortgage, you have $400,000 to put towards a down payment on your replacement property. You identify and purchase a property worth $500,000 and use your entire $400,000 as a down payment on the new property, which means you don’t receive cash boot. However, since you only need a $100,000 mortgage for your new property, your new mortgage is $150,000 less than your first one.
The IRS will consider the $150,000 as debt relief you received during your 1031 exchange, which means you now owe less debt on your current property. Debt relief does not qualify as like-kind property, so you’ll have to pay taxes on the $150,000. You can avoid this mortgage boot by choosing a more valuable property or an additional property to eliminate your debt relief.
As a second example, consider if you exchanged your property with a value of $500,000 and a mortgage of $225,000. You purchase your replacement property for $400,000 and take out a loan of $200,000. Because you originally had a loan for $225,000 and ended up with a loan of $200,000, that’s $25,000 in mortgage boot. Even though you technically never received any cash from the exchange, your debt amount is lower, creating mortgage boot that is subject to capital gains tax.
How to Calculate Boot
Knowing how to calculate potential boot can help you determine whether not rolling over all of your sales proceeds might be worth it or whether having a little bit of debt relief works for your needs, even if you’re taxed on it. While calculating boot can be a little complex, it’s important to know ahead of time so you aren’t surprised during and after your transaction if you have money left over. Boot calculation looks at two parts of the transaction — sale and purchase. On the sale side, you will have to consider the following items:
- Sales price
- Adjust tax basis
- Any liabilities owed
- Cost of commissions
On the purchase side, you will need to consider the following items:
- Price paid
- Transaction costs
If you can calculate the difference between these two parts, you’ll have a good idea of how much boot you may have. For instance, if there’s a difference between the cash you received from the sale and the cash you invested in the replacement property, it would be classified as boot, and you would pay taxes on the amount.
How Boot Is Taxed
As with boot calculation, determining how boot is taxed can also be complicated, leading to misunderstanding around the topic for many investors. While some may think that boot will reduce their basis in their replacement property, they may not realize that it will be taxable upon receipt. When an investor receives any boot in a 1031 exchange, it will be taxable to the extent of the gain. If you receive any boot, you will always face a taxable event.
The IRS will tax boot at the federal level, and you could face taxes at the state level depending on your location. Some states do not have personal income tax, so receiving boot would not trigger a taxable event at that level. If you own property or invest in different states, remember this before performing a 1031 exchange.
Because boot is listed as ordinary income on IRS form 8824, the specific tax rate will differ based on the investor’s tax bracket. For instance, if an investor received $50,000 in cash boot and is in the highest tax bracket — 37% — then they have a potential tax liability of $18,500. However, this liability with be combined with the investor’s other sources of income and expenses in their final tax bill, which is why it can be a complex process to identify the tax amount.
How to Avoid Boot in a 1031 Exchange
There are a few simple ways to avoid boot in your 1031 exchange. Here are some general rules to keep in mind:
- Avoid over-financing the mortgage on your replacement property.
- Work with a qualified intermediary to ensure you follow all rules of the 1031 exchange.
- Bring outside funds to pay for non-closing costs, such as tenant deposits or rent prorations.
- Ensure you select a like-kind replacement property that is of equal or greater value to your relinquished property.
- Reinvest all of your 1031 exchange proceeds, or net equity, from the relinquished property into the replacement property.
- Ensure the mortgage, or debt, on the replacement property is equal to or greater than that of the relinquished property to avoid debt relief.
- Check your contract to note whether any personal property, such as appliances, is included in the purchase price or can be a separate transaction.
Put Your Boot to Work
Another way to avoid boot and continue investing your money is through a Delaware Statutory Trust (DST). A DST is a real estate structure that enables investors to hold a fractional interest in a trust, which is established by a real estate company known as a sponsor. The sponsor acquires real estate assets, and investors own a beneficial interest in the trust, which means they hold a percentage of ownership.
With a DST, you can use the excess cash you receive from the sale of your relinquished property to acquire beneficial interests. This strategy allows you to choose the amount you want to invest, meaning you can allocate every penny of cash boot you receive from the 1031 exchange. Instead of accepting tax consequences on the excess cash, you can reinvest it in a DST, minimize or eliminate boot, and earn additional income.
For example, if you end up with a $50,000 boot after a 1031 exchange, you can take this entire amount and invest in a DST. Remember, though, that this co-ownership system has its benefits and potential risks, so it’s important to speak with experienced professionals about DST requirements and restrictions to determine whether this is a good fit for you.
Invest Your Boot in DSTs With 1031 Crowdfunding
You can create boot in a 1031 exchange in several ways, and these excess funds are subject to tax that can leave you with only a partially tax-deferred exchange. While paying taxes on this cash or debt relief may work for some investors, others may wish to find a way to eliminate it and avoid a taxable event. By investing your boot in a DST, you can potentially eliminate your tax liability and continue to expand your real estate investments.
With 1031 Crowdfunding, you can access an extensive online marketplace of 1031 exchange DST opportunities for your leftover boot from your exchange. Our platform empowers investors like you to learn more about DSTs, streamline your DST 1031 exchange process, and help you meet all requirements. Register for an account today to learn how to avoid boot and simplify your real estate investing.
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 is speculative in nature and involves 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.