1031 EXCHANGE BOOT: WHAT IS IT AND HOW DOES IT AFFECT MY EXCHANGE?
1031 EXCHANGE BOOT is any property received from your Section 1031 exchange that does not qualify as "like kind" to the Relinquished Property. Click here for a simple analogy.
Boot received can be in the form of money
or the fair market value (FMV) of the other property
received out of the exchange.
The most common (2) types of exchange boot are cash (i.e., when buying a cheaper Replacement Property than what the Relinquished Property was sold for) and a debt reduction (called "mortgage boot").
Although exchange boot is taxable at the current capital gains rate (to the extent of gain realized on the exchange), it is possible to have boot and still have a qualifying 1031 exchange (called a "partially taxable sale"). This is fine if you are willing to pay some taxes.
Inadvertently receiving boot in your 1031 exchange, and receiving an unexpected tax bill as a result of it, can be avoided by taking note of the following considerations.
1. Always "trade across" or up, but never "trade down," in order to avoid receipt of boot, either as cash, debt reduction, or both. The extra boot received can be off-set by qualified closing costs paid by you, the exchanger.
2. Bring cash to the closing of the Replacement Property to cover loan fees and/or other charges which are not qualified closing costs.
3. Do not receive property that does not qualify as "like-kind" to the Relinquished Property (such as property held for personal use, business inventory, partnership interests, and stocks and bonds). Vacation homes may qualify only under certain circumstances.
4. Do not over-finance the Replacement Property. Financing should be limited to the amount of money necessary to purchase the Replacement Property after the exchange funds are used up.
5. Do not access exchange funds. These must remain with the Qualified Intermediary ("QI") until the 1031 exchange is finalized, or else the transaction is blown. The QI is only permitted to release the funds to you under these 3 very limited situations
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6. Real estate investors who flip a lot of properties must be careful here. If you are classified as a real estate dealer for the properties that you own, those properties will be considered inventory and are not eligible for 1031 exchanges.
WHAT IS BOOT? Most of us have traded in a car in our lifetime and, the equation is something like this: [old car] + $ = [new car]. You trade in the old car, add some money either by check or through a car loan, and you “exchange” your car for a new one. That money “added” to the deal is "BOOT."
Boot received can be in the form of money
Money includes all cash equivalents, debts, liabilities or mortgages of you (the taxpayer, 1031 exchanger) that is assumed by the other party, or liabilities to which the property exchanged by you is subject.
"Other property" is property that is non-like-kind, such as personal property received in an exchange of real property, property used for personal purposes, or "non-qualified property." "Other property" also includes such things as a promissory note received from a buyer (which is called "seller financing") "Other Property" in this context may also include a promise to perform work on the property, business inventory, trade or stock in a corporation.
The most common (2) types of exchange boot are cash (i.e., when buying a cheaper Replacement Property than what the Relinquished Property was sold for) and a debt reduction (called "mortgage boot").
Although exchange boot is taxable at the current capital gains rate (to the extent of gain realized on the exchange), it is possible to have boot and still have a qualifying 1031 exchange (called a "partially taxable sale"). This is fine if you are willing to pay some taxes.
Inadvertently receiving boot in your 1031 exchange, and receiving an unexpected tax bill as a result of it, can be avoided by taking note of the following considerations.
1. Always "trade across" or up, but never "trade down," in order to avoid receipt of boot, either as cash, debt reduction, or both. The extra boot received can be off-set by qualified closing costs paid by you, the exchanger.
2. Bring cash to the closing of the Replacement Property to cover loan fees and/or other charges which are not qualified closing costs.
3. Do not receive property that does not qualify as "like-kind" to the Relinquished Property (such as property held for personal use, business inventory, partnership interests, and stocks and bonds). Vacation homes may qualify only under certain circumstances.
4. Do not over-finance the Replacement Property. Financing should be limited to the amount of money necessary to purchase the Replacement Property after the exchange funds are used up.
5. Do not access exchange funds. These must remain with the Qualified Intermediary ("QI") until the 1031 exchange is finalized, or else the transaction is blown. The QI is only permitted to release the funds to you under these 3 very limited situations
Sometimes, investors decide not to proceed with the 1031 exchange after selling the Relinquished Property -- or they have acquired some Replacement Property and decide NOT to acquire any additional property with the leftover exchange funds.
They then, understandably, expect the immediate return of the remaining funds held by the QI. However, a QI is generally only able to release the exchange funds to the exchanger upon 1 of the following 3 instances:
(1) the expiration of the 180 day exchange period;
(2) if no replacement property is identified within 45 days; or
(3) upon the acquisition of all identified Replacement Property to which the exchanger is entitled under the exchange agreement.
Otherwise, a Qualified Intermediary may only release the exchange funds to you, the exchanger, when a material substantial contingency to purchasing identified Replacement Property occurs, which is beyond the control of the exchanger and disqualified persons.
They then, understandably, expect the immediate return of the remaining funds held by the QI. However, a QI is generally only able to release the exchange funds to the exchanger upon 1 of the following 3 instances:
(1) the expiration of the 180 day exchange period;
(2) if no replacement property is identified within 45 days; or
(3) upon the acquisition of all identified Replacement Property to which the exchanger is entitled under the exchange agreement.
Otherwise, a Qualified Intermediary may only release the exchange funds to you, the exchanger, when a material substantial contingency to purchasing identified Replacement Property occurs, which is beyond the control of the exchanger and disqualified persons.
6. Real estate investors who flip a lot of properties must be careful here. If you are classified as a real estate dealer for the properties that you own, those properties will be considered inventory and are not eligible for 1031 exchanges.
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1. CASH BOOT
The "net cash received" at the closing of either the Relinquished Property or the Replacement Property will be considered cash boot to you and you will have to pay tax on that amount.. Cash boot is the most often the difference between the amount received from the sale of the Relinquished Property and the amount paid to acquire the Replacement Property (this is known as "trading down" properties).
Suppose the 1031 exchanger sells the relinquished property for $500,000. The 1031 exchanger decides to keep some of the proceeds for personal use, takes $15,000 of the proceeds and spends it on a car. That is, in its simplest form, “cash boot” and capital gains tax must be paid on this amount.
2. MORTGAGE BOOT
If the Relinquished Property has a mortgage on it, then the relief from that mortgage debt (when it's paid off in the sale) is considered mortgage boot to you UNLESS:
(a) the Replacement Property is mortgaged for an equal or greater amount of debt, OR
(b) you invest your own money towards the purchase of Replacement Property to offset the debt relief on the property sold.
1031 exchanger sells (old) Relinquished Property for $1,000,000 which has a $500,000 remaining mortgage on it. The 1031 exchanger buys a (new) Replacement Property for $1,000,000, but finances only $300,000 on that (new) Replacement Property. The 1031 exchanger does this by adding cash of $200,000 to the transaction. In this example, the 1031 exchanger “received” mortgage boot of $200,000 and “gave” cash boot of $200,000. So it is a wash and no taxable gains are recognized.
3. PERSONAL RESIDENCE BOOT
Investment property and personal residence property are not considered like kind property and cannot be exchanged. If you are buying a 4-family house as part of a 1031 exchange, and then use one of the units as your personal residence, then 1/4 of the property would be considered as a 1031 exchange taxable boot.
4. PERSONAL PROPERTY BOOT
Appliances (e.g., stoves and refrigerators) are typically attached to 1031 investment property but are personal property and are not like-kind to exchangeable real estate. Explicitly including such personal property in the exchange may cause a taxable event. Avoid this by simply stating in the deed that appliances are not "part of the sale" or create a separate 1031 exchange for those appliances (but consider that not all appliances are like kind to each other - stoves are not like-kind to refrigerators).
FORMULA FOR DETERMINING BOOT RECEIVED:
Mortgage on the old/Relinquished Property
- Mortgage on the new/Replacement Property
- Additional cash paid by you towards the new/Replacement Property purchase price *
= Net boot received (not less than zero)
+ Any cash received by you in the exchange
= Boot received
* This does not include the money invested in the new property from the sale of your old property
ORIGIN OF THE TERM "BOOT" Two cowboys met out on the range and decided to trade horses. One horse was worth more than the other, so the cowboy with the lesser valued horse, throws in one of his leather boots to even out the trade.
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