A 1031 exchange is a powerful tax code provision that can, when executed properly, allow a taxpayer to swap one business or investment property for another. An important topic to be familiar with when considering a 1031 exchange is the concept of “boot.”
What is boot?
It is possible that in a 1031 exchange transaction, the relinquished property (the property being sold) and the replacement property (the property being bought) are of different value. “Boot” in a 1031 exchange is money or other property that is received or deemed received by the taxpayer but is not of a “like-kind” to relinquished property (the real estate that the taxpayer sold) or the replacement property (the real estate that the taxpayer purchased) involved in a 1031 exchange. The taxpayer’s goal in a 1031 exchange is generally to avoid boot in order to successfully execute a tax-deferred transaction. If a seller does choose to receive boot, then he or she needs to be prepared to pay taxes on the value of the boot.
Common situations where boot may arise:
- Keeping some cash from the transaction. Cash sales proceeds received at the closing of the relinquished property that the taxpayer does not reinvest into replacement property during the 180-day 1031 exchange period will be considered boot. For example, if an investor sells the relinquished property for a net sales price of $1,000,000 but keeps $100,000 out of the net sales proceeds for personal use, then the $100,000 is boot. That is, in its simplest form, cash boot.
- Sale proceeds used to pay non-closing expenses at closing. If sales proceeds are used to pay costs at closing that are not the type of closing expenses that a taxpayer can use to offset sales proceeds during a 1031 exchange, then the result may be the same as if the investor received cash proceeds and used the cash proceeds to pay these costs. However, certain types of transaction and closing costs paid with cash proceeds offset cash boot received.
It is also important to note that payment of loan acquisition costs, such as origination and other fees related to acquiring the loan, from relinquished property sales proceeds may be considered boot and therefore may be taxable. This is determined by the IRS on a case-by-case basis.
- Debt reduction. Debt reduction boot, also known as mortgage boot, occurs when the debt encumbering the replacement property, whether assumed by the taxpayer or placed on the replacement property as part of the purchase, is less than the debt paid off by the taxpayer or assumed by the purchaser with respect to the sale of the relinquished property. Debt reduction boot can occur when an investor is buying a replacement property that has an adjusted gross purchase price that is less than the adjusted gross sales price of the relinquished property.
Rules of Offsetting Boot
√ Cash paid offsets cash boot received at the same closing table.
As an example, Bob puts down a $100,000 deposit for a replacement property from his own funds. At closing, the proceeds from his relinquished property are used to acquire the replacement property and, as a result, he is reimbursed $100,000 for the deposit at closing. The $100,000 he received at closing is cash boot, but the boot received is offset by the cash he paid for the deposit and these can be netted.
√ Cash paid offsets mortgage boot received.
Bob sells his property for $1,000,000, which was subject to a $500,000 mortgage that was either paid off at closing or assumed by the purchaser. He buys a replacement property for $1,000,000 but pays all cash for this property (including the net sales proceeds from the sale of his relinquished property). He received $500,000 in mortgage boot but paid $500,000 in his own cash and these can be netted.
√ Mortgage boot paid offsets mortgage boot received.
Bob sells his property for $1,000,000, which was subject to a $500,000 mortgage that was either paid off at closing or assumed by the purchaser. He buys a replacement property for $1,000,000 using the net sales proceeds from the sale of his relinquished property, a $300,000 new loan, and assumes the seller’s mortgage on the replacement property of $200,000. In this case, he received $500,000 in mortgage boot but offset it by placing the new loan on the replacement property and assuming the seller’s mortgage on the replacement property and these can be netted.
√ BUT an excess mortgage amount placed on or assumed with respect to the replacement property does not offset cash boot received.
Bob sells his property for $1,000,000, which was subject to a $500,000 mortgage that was either paid off at closing or assumed by the purchaser. He buys a replacement property for $1,000,000, using only $300,000 of the net sales proceeds from the sale of his relinquished property and a $700,000 new loan on the replacement property and thus receives $200,000 of his net sales proceeds from the sale of his relinquished property back at closing. Bob placed $200,000 more in mortgage debt on his replacement property than he had on his relinquished property and received $200,000 in cash boot at closing, but the excess mortgage amount of $200,000 cannot offset the $200,000 in cash from his 1031 exchange that he received, and thus he will be liable for tax on the $200,000 cash boot.
In general, an investor that wants to avoid paying taxes in a 1031 exchange transaction should look to purchase a “like-kind” replacement property with a value equal to or greater than the value of the relinquished property. Investors should also plan to reinvest all of the net sales proceeds from the sale of their relinquished property and make sure that either the debt on the replacement property is equal to or greater than the debt on the relinquished property or, if the debt on the replacement property is less than the debt on the relinquished property, that he or she funds the difference with his or her own cash.
Obviously, the goal in any 1031 exchange is to have an efficient and successful transaction. There are situations, however, like we’ve discussed here when “boot” comes into play, that can have an impact on an investor’s ability to use the full tax-deferral benefits afforded by the 1031 exchange. Understanding how boot works will allow you to inform and educate clients well in advance of an exchange, helping to avoid any surprises or misunderstandings