1031 Exchange “Boot”

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 .

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.

    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).

    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.


    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

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