The term “boot” is broadly defined as a taxpayer’s receipt of non-like-kind property in a 1031 exchange. As discussed more fully below, boot can come in many different forms. However, it is important to note that receipt of boot will not completely disqualify a 1031 exchange. Rather, only the amount of boot received by the exchanger will be taxable.
The most common form of boot is known as “cash boot,” which occurs when the exchanger receives a portion of the cash proceeds from the sale of their relinquished property. For example, an exchanger may elect to have a portion of the net proceeds from their relinquished property go directly to them instead of going to their 1031 exchange accommodator. Another typical cash boot scenario occurs when an exchanger does not use up all of their exchange funds, either because they purchased replacement property that is of lower value, or because they took out too large a loan to acquire their replacement property, and there is cash left over in their 1031 exchange account. In both instances, the cash received by the exchanger is considered boot and will be taxable as capital gains.
Another form of boot is commonly referred to as “debt boot.” Debt boot occurs when sale proceeds are used to pay off debt upon the sale of the exchangers relinquished property, and such debt forgiveness is not offset with new debt or with outside cash used to acquire a replacement property. For example: an exchanger sells their relinquished property for $1 million, pays off a mortgage of $300K, and nets $700K (before closing costs). The exchanger then pays all cash for a $700K replacement property and purchases no other replacement property. This exchanger will recognize (and be taxed on) $300K of debt boot.
Installment Note / Seller Carryback
When an exchanger carries a note for the buyer of their relinquished property, all payments of principle received by the exchanger under the note are considered boot and are therefore taxable. One way to get around this is to have the note payable to the exchanger’s qualified intermediary (QI), and for the buyer to then make payments on the note to the QI. However, all payments on the note that are made after the exchange is completed are considered boot and will be taxed. Another solution is for the exchanger/seller to fund the note with their own cash (the same way a traditional lender would). However, this method is often impractical, as many sellers do not have enough cash on hand to fund the note. See our article on Seller Financing and 1031 Exchanges for more information.
Personal Property / Non-Qualifying “Closing Costs”
Sometimes exchangers inadvertently (or not so inadvertently) use exchange funds to pay for non-qualifying expenses through escrow on either their relinquished or replacement property. Some examples of such expenses are: furniture or appliances that are being purchased from the seller of the replacement property; repairs to the property; property taxes; and rent/security deposit prorations. Use of exchange funds to pay for such non-qualifying expenses may be looked upon as receipt of boot and therefore result in tax liability. See our article on Closing Costs in 1031 Exchanges for more information.
How is Boot Taxed?
Boot received by an exchanger is treated as capital gains and is taxed in the same manner. The amount of boot that can be taxable is, of course, limited to the amount of capital gains that would have been recognized had the exchanger not elected to conduct a 1031 exchange. For example, if an exchanger has $300K in debt boot, but would only have recognized $200K in capital gains on the sale of their relinquished property, they will only pay taxes on the $200K.
Below is a list of strategies that exchangers often employ to reduce boot or avoid it altogether:
- Purchase replacement property of equal or greater value than one’s relinquished property AND use all of the equity from the relinquished property towards the purchase of replacement property. See our article on Balancing the Equities in a 1031 Exchange for more information.
- Use leftover equity (cash) in the 1031 exchange to purchase additional replacement property. Delaware Statutory Trusts (DST) and Tenant in Common (TIC) interests are often easy solutions. If there is significant debt boot, an exchanger may want to consider purchasing a fractional ownership interest in a Delaware Statutory Trust (DST) that has high leverage in order to “make up” the debt replacement requirement for their exchange.
- Debt boot can be offset with outside cash (i.e. cash that is not part of the 1031 exchange funds) used towards a replacement property.
- Apply carryforward losses to the capital gains recognized as a result of receiving boot.
- Cost segregation study on replacement property, accelerated and /or bonus depreciation deductions, deductions under IRC Section 179, in order to offset capital gains. See our article on How Cost Segregation Studies can Increase your Tax Savings for more information.
Please speak with your tax advisor and contact one of our 1031 exchange experts for more details.
If you or someone you know has questions about the 1031 exchange process, we at Peak 1031 Exchange are your qualified experts who are here to help. Contact us today at [email protected] or by calling us at 866-357-1031 to discuss the deferral of capital gains taxes with a 1031 exchange.