Understanding Taxable Boot in 1031 Exchanges

What is a 1031 exchange “boot,” and what should you do to avoid one?

Contrary to what you may have heard, a 1031 exchange isn’t an all-or-nothing proposition. It’s possible to conduct a successful 1031 exchange, but still owe some capital gains tax on the transaction. When this happens, the taxable portion of the deal is known as a 1031 exchange “boot.”

Boot is one of those terms you need to know before embarking on your first 1031 exchange. While some exchangers consider it a worthwhile trade-off to pay some tax in exchange for cashing out equity, the goal of most 1031 exchanges is to defer all the capital gains taxes they can. To accomplish this, you must understand the scenarios that generate a taxable boot in a 1031 exchange and how to avoid them.

The difference between a 1031 boot and a failed exchange

Having boot does not mean that you weren’t able to defer taxes with a 1031 exchange, or that your exchange failed. A failed exchange is when taxes are not deferred, either because you didn’t ultimately acquire a like-kind property, some 1031 rules were violated, or your exchange was disallowed for another reason, like the property was a primary residence, wasn’t used for business purposes for long enough, or the exchanger was ruled to be a dealer of real estate. In these situations, taxes are due on the sale of the relinquished property, even if you acquired a replacement property you believed would qualify.

The tax burden for a failed 1031 exchange can be significant, which is why some exchangers hedge against failure by tax straddling, or include Delaware Statutory Trusts (DSTs) as backup replacement properties. But even if your exchange is technically successful, you could still owe some capital gains taxes on the relinquished property sale.

Common scenarios that trigger a taxable boot in a 1031 exchange

Boot happens when the property you acquire is worth less than the property you sold, or the expenses for the exchange were not considered allowable costs. Many types of 1031 exchanges result in a taxable boot: improvement exchanges can result in boot when not all scheduled improvements were made; exchanges for farmland can involve non-real property that doesn’t qualify; and mistakes in calculation of debt ratio can result in a replacement property that isn’t valued the same as the relinquished property. In these situations, you’ll owe taxes on part, but not all, of your relinquished property sale, while the rest of your tax burden will be deferred through the 1031 exchange.

Cash boot vs mortgage boot in 1031 exchanges

The simplest type of 1031 exchange boot: the “cash boot”

Many people believe that IRC Section 1031 requires the replacement property to be worth at least as much as the relinquished property. While this is usually desirable, it isn’t a requirement. However, if you want to fully defer capital gains taxes with a 1031 exchange, finding a property worth more than the one you’re selling is a must.

Let’s say you sell your existing property, on which you carry no mortgage, for $500,000, and you buy your replacement property for $400,000 (with no mortgage). As long as all other 1031 exchange qualification criteria are met, you can still complete this exchange. But because the replacement property was worth less than the relinquished property, only the portion of the sales proceeds used for the acquisition of the replacement property will be eligible for tax deferral. In this case, you will be left with a $100,000 “cash boot,” which will not be covered by the exchange, and will therefore be subject to capital gains taxation.

There are ways to avoid this taxable boot. You could purchase a different replacement property of higher value that wouldn’t generate boot. But if you’re set on a lower-value replacement property, remember that a like-kind exchange can involve more than one replacement property. In this scenario, you may be able to invest the difference in a second property, such as a DST interest, to avoid taxation.

The replacement property is more valuable, but I still owe taxes?

The preceding figures assume an all-cash exchange. Things become slightly more complicated when mortgages are involved in a 1031 exchange.

Consider an exchange scenario in which you sell a relinquished property valued at $500k, with an existing mortgage of $350k, repaid in full at closing. You then acquire a replacement property valued at $600k and make a 20% cash down payment, meaning the mortgage on the replacement property is $480k. In this case, you have taken $150k in equity out of the relinquished property and only reinvested $120k. You’ve effectively cashed out $30k in equity, creating a net taxable cash boot, even though the replacement property’s value was higher.

You may determine that due to the terms of the new mortgage, this makes financial sense. If not, you could seek a property (and mortgage) that would leave you without a taxable boot, or look for a second replacement property. But don’t assume you won’t have boot just because a mortgage is involved, because there are many scenarios that involve both a mortgage and boot.

A 1031 “mortgage boot” scenario

Just as you must avoid cashing out equity in a 1031 exchange, you must also avoid reducing your debt obligations.

Consider this scenario: You sell a relinquished property valued at $500k, with an existing mortgage of $350k. You then acquire a replacement property valued at $450k. You know from the example above that you need to reinvest all of your equity ($150k) into the new property, so you take out a mortgage of $300k.

In this case, even though you rolled all of your equity forward, you have benefited from debt relief in the process ($300,000 vs. $350,000), so you’ve generated a $50,000 mortgage boot which is taxable in a 1031 exchange.

Note that you can reduce your debt obligation and still defer tax, but you need to offset it by adding cash. In the case above, if the replacement property was valued at $500k instead of $450k, you could take out the same mortgage of $300k, but offset the $50k in debt relief ($300,000 vs. $350,000) by adding $50k cash to offset the net debt relief.

This specific scenario may be uncommon, but the important thing to remember is that it’s possible to add cash and reduce debt during a 1031 exchange. The opposite – adding debt and taking out equity – is not treated the same way by the IRS. You’ll need to calculate taxes owed on the boot based on your original basis for the relinquished property, which is why it’s important to consult tax and legal professionals familiar with 1031 exchange rules before performing your exchange.

Avoiding 1031 boot with Delaware Statutory Trusts

We’ve mentioned that adding a Delaware Statutory Trust (“DST”) as a second property in your exchange can be a way to avoid a taxable boot and achieve full capital gains tax deferral. But what about when you have debt on your relinquished property?

In this case, you would have to replace that debt with a similar level of debt on your replacement property. Doing so with a DST (or series of DSTs) actually isn’t as hard as you might think, because many DSTs are designed with 1031 investors in mind.

There are different kinds of DSTs, including single-property and multi-property, as well as those with specific debt ratios so 1031 exchange investors can more easily defer taxes by selecting the specific DST that’s right for them. When choosing between a DST and a whole property exchange, debt ratio and the ability to achieve complete tax deferral in a 1031 exchange should be taken into account.

Want a tax-free 1031 exchange?

If your goal is to defer all possible capital gains taxes on your 1031 exchange, you need to carefully structure the exchange to avoid any surprises. You’ll need competent tax and legal advisors to help you follow the law, and adhere to all 1031 rules. You also have to work with a third-party Qualified Intermediary (QI) to hold funds during the exchange. To avoid costly errors, you’ll need a Qualified Intermediary experienced in 1031 exchanges that can handle the unique nature of your exchange.

At JTC, we’ve put together an industry-leading track record as a 1031 exchange QI thanks to a commitment to best practices and an experienced team that has specific expertise in less-common scenarios like reverse exchanges and those involving DSTs. All of our 1031 clients get access to our 24/7 online portal and security features designed to eliminate the type of errors that can doom one’s chances for tax deferral in a 1031 exchange.

It may be tempting to work with whichever QI is cheapest, but that can lead to mistakes that result in an unexpected taxable boot, or worse, a failed exchange. If you want your exchange to have the strictest security measures, fullest transparency, and most attentive client service possible, work with JTC, where you’ll always get our best.

Learn more about JTC’s 1031 exchange services