Any real estate investor who has performed a 1031 exchange knows the intricacies behind successfully completing the “perfect” exchange. The idea behind a 1031 exchange is to cash in on profits, defer capital gain taxes and move your equity into better cash flowing assets. As discussed in previous articles, there are strict rules behind a 1031 exchange and if broken, can lead to heavy tax consequences.
What is 1031 Exchange Boot?
1031 Exchange Boot, commonly referred to as "boot" is an old English term pertaining to "exchange in addition to." In this case, boot is cash or other property added to an exchange to make the value of the traded good equal. Because it is difficult to find two “like-kind” properties of identical value to exchange, one party (purchaser) will commonly contribute cash and/or physical property to make the value of the exchange equal to or better.
Types of 1031 Exchange Boot
To successfully complete a 1031 Exchange, the purchaser must exchange the relinquished property for an equal or greater amount including value (purchase price), equity and debt.
For example, if you sell a property for $1,000,000 and purchase another for only $800,000, the difference of $200,000 is referred to as boot. In this scenario, the IRS will recognize the unused proceeds from the relinquished property as taxable boot.
Boot can result from several factors in a real estate investment exchange. Below are the most common types of boot in real estate.
At closing, sales proceeds can create excess boot if they are used to pay non-qualified expenses not considered as closing costs such as service costs. Using sale proceeds for non-transaction related costs are treated as if cash was received from the exchange and used to cover outside costs. Examples of non-transaction costs include:
Paying for these items out-of-pocket will avoid turning sale proceeds into boot.
Equity or Cash Boot
When cash received from the relinquished property's sale is greater than the cash used to purchase the replacement property, you will trigger excess “income” resulting in a taxable event.
For example, if you sell a property for $1,000,000 with $500,000 in equity and $500,000 in debt (50% LTV) and reinvest only $400,000 with $600,000 debt (60%LTV) into the replacement property, the difference of $100,000 in equity is referred to as boot.
In some cases, cash boot can be a result of interest earned from a promissory note or repairs paid for by a seller further credited to the buyer.
Mortgage Boot or Debt Reduction Boot
Mortgage boot or debt reduction boot may occur when the leverage (debt) amount is used on the acquired property is less than the leverage used on the relinquished property. Reducing your debt liability is considered “phantom” income because it is cash once owed that will remain in your pocket at the time the debt matures.
For instance, if your replacement property's mortgage is $200,000 and your relinquished property's mortgage was $300,000, then you will have a $100,000 debt reduction boot.
When creating excess boot, only the net boot amount will be taxable. Excess boot may be offset in several ways including:
Although boot does not cancel a 1031 exchange, it may result in a tax liability. The idea behind performing a 1031 exchange is to realize profits, defer taxes and move your equity into a better property. The 1031 exchange is designed for investors to “trade up” in assets forcing the exchanger to satisfy equal to or greater value, equity and debt. Trading down will always result in boot received, so aim to trade up or across.
Investing in a Delaware Statutory Trust is a great way to diversify your portfolio into greater quality properties while easily satisfying the 1031 “trade-up” rules on value, equity and debt.
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