If you are doing a 1031 exchange or looking forward to doing one, one of the major factors that determine if you are liable for any taxes is a concept known as boot. A 1031 exchange when properly done can offer you ample of tax benefits. You can easily defer the payment of capital gains taxes and depreciation recapture tax by reinvesting sale proceeds of your investment property into another investment property.
Unfortunately, not all 1031 exchange transactions may be eligible for tax-deference. To understand the reason behind this ineligibility, you need to understand the concept of boot.
What is Boot in 1031 Exchange?
If you received cash from the sale of your relinquished property or bought a replacement property with a lower debt, then the difference is regarded as Boot. Boot received in a 1031 exchange is subject to capital gain taxes.
How Does Boot Work in a 1031 Exchange?
When doing a 1031 exchange, there are two IRS-stipulated rules that you must meet to be eligible for a fully-tax deferred exchange.
- A rule of thumb when doing a like-kind exchange is that the replacement property must be equal or greater in value than the relinquished property. So, if you sold your relinquished property for $200k and purchased a replacement property for $300k, then you meet the requirement for full tax deference.
- The amount of debt taken on the replacement property must be equal or higher than the remaining debt of the relinquished property at the time of sale. In clearer words, you cannot reduce your debt when doing a 1031 exchange. So, if the mortgage balance of the relinquished property at the time of sale was $200k, then your replacement property must have an equal or higher debt level.
Can I Still Do A 1031 Exchange After Receiving Boot?
Yes, you can still do a 1031 exchange even if you miss out on the IRS requirements above. The only difference is that it will not be completely tax-free. 1031 exchanges are not compulsorily a fully-tax deferred strategy.
That is, you can defer the payment of capital gains taxes on some of the realized gains by reinvesting some but not all of the proceeds into the purchase of a replacement property. This is known as a Partial 1031 Exchange.
When doing a 1031 exchange there are two main types of Boots that you most likely to receive. They include:
- Cash Boot
Cash boot occurs when the cash received from the sale of the relinquished property is greater than the cash paid for the purchase of the replacement property. This usually applies to property exchange without mortgage debt. For example, if you sold your relinquished property for $300k and purchased a replacement property for $200k, you will receive a cash boot of $100k. The IRS considers the extra $100k as income, and income is taxable.
- Debt Reduction Boot
This is also known as mortgage boot. Debt reduction boot occurs when the debt owed on the replacement property is lower than the debt owed on the relinquished property. Since the IRS guideline requires that debt on the new property must be equal or greater than that of the old property, then the difference in the debt is subject to capital gains taxes.
For example, if you sold your relinquished property for $400k with an outstanding debt of $200k, and purchase another property for $300k with mortgage balance of $100k, you will have received mortgage boot even though you reinvested all your equity in the new property. An easy way to avoid mortgage boot is to add cash to the deal to cover the difference in debt on the replacement property. It is your qualified intermediary responsibility to help you out with this.
Is Receiving Boot Worth It?
While there is a serious misconception about receiving boot in a 1031 exchange, sometimes receiving boot can be a great idea. If you are selling an investment property, you may need extra money to cover you and your family living expenses or do other personal projects. Doing a partial 1031 exchange or receiving boot will help you defer tax on some of the gains and receive cash (pay tax on) on the remaining part.
If you’re interested in deferring taxes on 1031 Exchange Boot,