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Understanding Taxable Boot in 1031 Exchanges

28th Sep 2023
What is a 1031 exchange “boot,” and what should you do to avoid one?

Contrary to a somewhat popular misconception, 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 “boot.”

While some exchangers will 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 taxes on the transaction. To accomplish this, you must understand the scenarios that generate boot and how to avoid them.

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, unless the exchanger wants to avoid all taxes.

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 (and no mortgage). As long as all other qualification criteria are met, you can still complete an exchange — but only part of the gain on the sale will qualify 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 taxation.

There are ways to avoid this boot. You could purchase a different replacement property of higher value that wouldn’t generate a 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.

Consider an exchange scenario in which you sell relinquished property valued at $500k, with an existing mortgage of $350,000, which is repaid in full at closing. You then acquire a replacement property valued at $600,000 and make a 20% cash down payment — meaning the new mortgage on the replacement property is $480,000. In this case, you have taken $150k in equity out of the relinquished property and only reinvested $120,000. You’ve effectively cashed out $30,000 in equity, creating a net taxable cash boot even though the replacement property 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 leaves you without a taxable boot, or seek a second replacement property as with an all-cash transaction. But don’t assume you won’t have a boot just because a mortgage is involved, because there are many scenarios that involve both a mortgage and a boot.

A “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 relinquished property valued at $500,000, with existing mortgages of $350,000. You then acquire replacement property valued at $450,000. You know from the example above that you need to reinvest all of your equity ($150,000) into the new property, so you take out a mortgage of $300,000.

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

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 $500,000 instead of $450,000, you could take out the same mortgage of $300,000, but offset the $50,000 in debt relief ($300,000 vs. $350,000) by adding $50,000 cash to the purchase 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 an exchange or take cash out and increase debt. Either way, 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 before performing your exchange.

Want a completely tax-free 1031 exchange?

If your goal is a 100% tax-free 1031 exchange, you need to carefully structure your exchange to avoid any surprises. You’ll also need to follow the law and adhere to all 1031 rules. To do that, you’ll need a Qualified Intermediary (QI) that can handle the unique nature of your exchange.

At JTC, we’ve put together an industry-leading track record as a QI thanks to a commitment to best practices. Members of our legal and Client Services teams have decades of experience handling exchanges, and our secure online portal offers 24/7 access to exchange information from anywhere in the world. We also have experience with all manner of exchange scenarios, including reverse exchanges and those involving Delaware Statutory Trusts.

If you’re considering a like-kind exchange, you’ve come to the right place. Schedule a free consultation (with no obligation) by filling out the form below!

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