Guide to Taxable Boot
When you perform a 1031 exchange, it’s normal for the properties that you swap to not be of equal value. This isn’t a problem when the less valuable property is the one you’re leaving. However, you may end up still owing taxes if the less valuable property is your new acquisition. This is because the IRS believes that you’ve received “something extra” in addition to the new property, and they want to tax that “something extra.”
Here is an analogy: say you collect baseball cards and want to trade one card with a friend. Your card is worth $200, while your friend’s card is worth $150. To make up the difference, they also give you $50 cash.
In colloquial terminology, the $50 is an example of “boot”, which is old-school vernacular for money or other property received to equal out a trade. In a 1031 exchange, boot is taxable and is something you want to avoid to maximize your tax deferment savings.
(We will explain what might count as “boot” in your 1031 exchange – and how to avoid it!)
What is taxable boot?
The term “boot” gets used a lot, but you won’t find it in the Treasury Regulations or Internal Revenue Code. While there are many examples of real estate boot, the simplest way to define it is any property received during an exchange that isn’t like-kind. Typical examples of 1031 exchange boot include:
1. Cash boot, such as when you elect not to reinvest all of the proceeds from your sale into your new property.
2. Mortgage boot, such as when, on net, your mortgage on the new property is smaller than the mortgage on your old property.
3. Personal property boot, such as when part of the property you receive is not used for business or investment purposes.
Since the IRS does not consider boot to be “like-kind property”, it doesn’t qualify for tax deferment. This means you need to pay capital gains and other applicable taxes on the value of any boot you receive during your exchange.
What is cash boot?
Cash boot is money you directly receive when you sell your property through a 1031 exchange. You might receive cash boot at the time of sale by withholding some money from your 1031 exchange’s escrow account. You might also receive cash from the escrow account at the end of the exchange.
As a good rule of thumb, consider that any money you receive from the sale of your property will be considered taxable income.
The goal of section 1031 is to encourage investment to boost the economy. The IRS penalizes anyone who diverts some cash away from investments, for whatever reason, by taxing the cash value.
How cash boot happens?
You can end up with cash boot after an exchange in several cases.
Example 1: Imagine you sell a property for $325,000 — $100,000 more than you originally paid — with $15,000 in closing costs. Here, your capital gain from the sale is $85,000 ($100,000 minus $15,000 closing costs).
As part of your like-kind 1031 exchange, you purchase a replacement property worth $275,000. Closing costs are $10,000, bringing the net replacement value up to $285,000. Since you relinquished the first property for $310,000 ($325,000 minus $15,000 closing costs), this still leaves a $25,000 difference between the relinquished property value and the replacement property value.
After the exchange, you receive the leftover $25,000. The IRS is going to tax those $25,000, so now your 1031 exchange can only defer taxes on $60,000 of the original $85,000 worth of gains from your old property.
Example 2: Now imagine that you sell that same property for $325,000. You still originally paid $225,000 and had $15,000 in closing costs, and you still need to defer $85,000 worth of capital gains through your 1031 exchange.
Only this time, you decide that you need to pay off $10,000 of credit card debt. So rather than put all of the sale proceeds from your property into a 1031 exchange escrow account, you withhold $10,000 from sale and deposit it into your checking account.
Now, let’s say you found a replacement property for $400,000 with closing costs of $30,000. Your total net acquisition value is $430,000. Even though the second property costs more than the first, since you diverted $10,000 from your escrow, you must still pay tax on it. Again, the IRS sees this as value received from your exchange that cannot be classified as “like-kind” property.
(Note: Personal property boot is a sub-category boot. It’s less common but worth being aware of, especially if your exchange includes machinery, inventory, or other property types that aren’t classified as real estate.)
What is mortgage boot?
Mortgage boot is another big category of taxable boot. This can get technical very quickly, but you are likely to end up with mortgage boot whenever you buy a property that carries a smaller mortgage compared to the property you sold.
Mortgage boot is also called debt relief boot, as you are trading a higher-priced loan for a less expensive option.
Example: You sell a $450,000 property with $150,000 remaining on your mortgage. Once the $150,000 mortgage is paid off, you have $300,000 to put towards a down payment on the replacement property. You decide to purchase a property worth $400,000. You use all $300,000 as down payment on the new property – meaning you don’t receive cash boot – but you only need a $100,000 mortgage to complete the purchase. This is $50,000 less than your first mortgage.
The IRS considers the $50,000 difference to be debt relief received as part of your exchange. Since debt relief doesn’t qualify as like-kind property for a 1031 exchange, you’ll need to pay taxes on the $50,000.
(Note: It is possible to offset mortgage boot if you are buying a more valuable property. Let’s say you buy a $500,000 replacement property instead, but you want to bring in $100,000 of outside cash to make your down payment $400,000. In this case, you still only need a $100,000 mortgage to complete your trade, and this is still smaller than the $150,000 mortgage on the old property. Even though you receive some debt relief this way, the $100,000 that you contributed into the exchange can offset the $50,000 in mortgage boot.)
Cash vs. mortgage boot
There are several important differences between cash and mortgage boot. Obviously, with cash boot, you either get cash or its equivalent directly and it’s much easier to see and calculate. With mortgage or debt relief boot, you need to carefully track your net liabilities after the exchange, such as a smaller mortgage, and make sure to include any boot offsets. It’s very important to understand that cash boot can never be offset. You cannot, for example, receive cash at the time of your sale and then offset it by adding back in new money later when you buy the replacement property.
The applied tax rate on cash v. mortgage boot is the same. There is no strategic tax advantage by favoring one type of boot over another. In every case, it is most tax efficient to avoid receiving any type of boot and instead complete a fully deferred 1031 exchange.
Also note that it is possible to have both cash boot and mortgage boot, but the IRS will only tax you on the larger of the two amounts. For example, if you take $10,000 in direct cash from your sale and then subsequently receive mortgage boot worth $50,000, then the IRS will only count the $50,000 mortgage boot. You won’t pay taxes on the combined $60,000 of boot.
Two rules to avoid boot
The goal of a 1031 exchange is to defer taxes and maximize your long-term investment potential. Avoiding boot allows you to most efficiently use your built up capital and make the most of your investment.
Following two simple rules can help you avoid boot in almost all circumstances.
Trade equal or up in value
When you perform a 1031 exchange, the IRS ultimately wants you to increase the net amount of resources invested into the real estate market. The tax benefits are heavily slanted in favor of buying more valuable real estate. Consequently, the number one tax mistake that exchange investors make is failing to buy enough replacement property.
This doesn’t necessarily mean that you have to buy super expensive real estate – another option is to exchange one property for two or more. Just make sure that, when combined, the value of those properties equals or exceeds the value of your relinquished property.
Transfer all of your equity
Equity is the value of your assets minus any associated debts. If you own a $400,000 property and have a $250,000 mortgage, you have $150,000 in equity. When you sell that property as part of a 1031 exchange, all $150,000 of that should be directed to your exchange account and subsequently used as down payment on the replacement property. Otherwise, the IRS considers any non-transferred equity as taxable boot.
Can you avoid taxable boot by bringing outside cash to the exchange? Again, no. If you have $200,000 in equity but need to take $50,000 to pay off a loan or other obligation, the IRS considers the $50,000 to be cash boot, even if you make up the difference with $50,000 from another source at closing.
Get answers to your questions about taxable boot
Transferring your equity and exchanging for a higher value property are two easy ways to avoid boot in your 1031 exchange. But your situation might be more nuanced. Let a 1031 expert help you through the process. If you’re ready to start an exchange, contact us to set up a free consultation today.
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