Like-Kind Exchange and “Boot”



Not every 1031 Exchange qualifies for full tax deferral.

1031-exchange-rules-avoid-taxable-boot

What Is “Boot”?

“Boot” is old financial parlance that means “value given in addition to.” In a 1031 Exchange, “boot” is anything received by the taxpayer that is not like-kind property. The IRS taxes the value of boot items.

You won’t find the term “boot” in the Internal Revenue Code. And it does not appear in the Treasury Regulations.

The term is common in car trades. So if a new car trades for an old car, the owner of the old car often brings extra money (aka boot) to even out the trade.

In a 1031 exchange, boot is anything received by the exchanging seller that is not like-kind property.

We go over some easy examples so you can see how it applies.

Cash vs Mortgage Boot

The IRS doesn’t like it when you directly receive some of your sale proceeds (Cash Boot) or receive net mortgage relief (Mortgage Boot) as the result of a 1031 Exchange.

Regulators designed Section 1031 to promote investment in the economy. This means the IRS wants to tax any value that you do not directly exchange into another investment property.

There are two kinds of taxable value:

Cash Boot
Example #1

A taxpayer will pay taxes on any equity (net proceeds) of their relinquished property sale that they receive directly—even when this occurs after successfully purchasing a like-kind property. This would be considered Cash Boot.

Sean owns a $300,000 investment property free and clear. He wants to do a 1031 exchange into a $250,000 condo. There will be $10,000 in closing costs at his sale and at his purchase.

$300,000 – Sean’s relinquished property
$200,000 – Tax Basis
$10,000 – Closing Costs
____________________________
$250,000 – Sean’s replacement property
$10,000 – Closing Costs

Here, Sean faces a capital gain of $90,000 (selling $100,000 above his basis minus the $10,000 in closing costs). After considering another $10,000 in closing costs when he purchases his condo, the net value of his replacement property is $260,000.

Unfortunately, here Sean trades down in value by $30,000 (the difference between the net relinquished price and the net replacement).

The way the IRS sees things, Sean traded a $290K asset for a $260K asset plus $30K in cash. Cash is not like-kind to real property, so Sean can only defer $60,000 of his capital gain ($90K – $40K in boot).

That $30K in net cash received by Sean represents “cash boot”.

Cash Boot
Example #2

A taxpayer will also trigger taxes if they opt to receive some cash out at the closing of their relinquished property. This is also Cash Boot.

Jen owns a $300,000 investment property free and clear. She wants to do a 1031 exchange into a $325,000 condo. There will be $10,000 in closing costs at his sale and at his purchase, but Jen also wants to receive $15,000 of her proceeds directly.

$300,000 – Jen’s relinquished property
$200,000 – Tax Basis
$10,000 – Closing Costs
$15,000 – Cash Received at Closing
____________________________
$325,000 – Jen’s replacement property
$10,000 – Closing Costs

Here, Jen took out $15,000 from her sale to pay back an old loan from her parents. Since that $15K did not go into the 1031 escrow account and eventually make up part of the down payment to her replacement property, it became fully taxable.

It does not matter that Jen bought a more valuable replacement property ($335K vs $290K). The $15,000 is cash boot; Jen can only defer $75,000 of her capital gain ($90K – $15K in boot).

Now, a clever investor might ask “What if Jen brought another $15K in outside funds to the replacement closing?”

No dice. Jen still recognizes $15K in cash boot.

Cash Equivalents

Cash is not the only asset that triggers Cash Boot. There are several other items (called “cash equivalents”) that the IRS treats just like cash.

Any item of value that is not like-kind property received as consideration for the relinquished property will be treated like cash boot.

Here are a few common examples:

  • Rent prorations
  • Repair and maintenance expenses
  • Tenant deposits
  • Promissory note from a buyer*

**With a promissory note, the face value is taxed as cash boot. Any interest received will taxable as regular income in the same tax year that you receive the corresponding payment. There are some smart ways around this problem.

Mortgage Boot Example #1

This issue can get complicated. But avoiding Mortgage Boot is actually very simple. Taxpayers can avoid triggering any mortgage boot items by acquiring replacement property that is worth at least as much as their relinquished property.

First, let’s look at an example with where mortgage boot applies.

$650,000 – For the Birds LLC’s relinquished property
$350,000 – Tax Basis
$200,00 – Remaining Mortgage Debt Owed
$20,000 – Closing Costs
$430,000 – Net Equity
____________________________
$575,000 – For the Birds LLC’s replacement property
$430,000 – 1031 proceeds as down payment
$20,000 – Closing Costs
$145,000 – New Mortgage Loan

Here, For the Birds LLC faces $280,000 in capital gains (after closing costs). It will not incur any cash boot because the LLC transferred 100% of net equity from the relinquished property to the replacement property as down payment.

The IRS still sees a problem.

Why? Because the IRS says that For the Birds LLC traded a $630K asset for a $595K asset plus $45K in net debt relief.

Debt relief is not like-kind to real property.

So this LLC can only defer $255K of its capital gain ($300K – 45K in boot).

Mortgage Boot Example #2

There is a myth that you automatically owe Mortgage Boot if you have a smaller mortgage on the replacement property. In fact, taxpayers in a 1031 Exchange can offset a lower amount debt with new cash and avoid boot.

There is a LOT of incomplete information about mortgage boot out there.

Here’s a simple rule:

You do not need an equal amount of debt on your replacement property in a 1031 exchange. You only need to replace the full value of the debt.

Yes, trading into a property with a larger mortgage does avoid mortgage boot. But remember you can also deleverage by bringing outside cash to make up the difference.

Take this example:

$650,000 – For the Birds LLC’s relinquished property
$350,000 – Tax Basis
$200,00 – Remaining Mortgage Debt Owed
$20,000 – Closing Costs
$430,000 – Net Equity
____________________________
$650,000 – For the Birds LLC’s replacement property
$430,000 – 1031 proceeds as down payment
$20,000 – Closing Costs
$145,000 – New Mortgage Loan
$55,000 – Outside Cash

Here, For the Birds LLC transfers all net equity (avoiding cash boot). The LLC also reduces its net debt burden by $55,000.

By bringing additional new cash, the LLC fully replaced the value of its old mortgage debt of $200,000. The LLC does this with a combined $145,000 in new debt and $55,000 in outside (non-1031) cash.

Even though its new property carries less debt, the LLC does NOT face mortgage boot. This is a fully tax-deferred exchange.

Have Questions About a 1031 Exchange? Get a Free Consultation

Bonus: Personal Property

Appliances, inventory, and other PP&E do not count as valid replacement assets in a 1031 Exchange. Using 1031 sale proceeds to pay for these items will trigger Personal Property Boot (which is a subset of Cash Boot).

This is pretty rare for most investors, but we think it’s worth planting a flag here. If you or your business work with appliances, inventory, and other non-real estate assets, pay particular attention.

Consider the following scenario:

  1. You identify a $2 million Widget factory and warehouse.
  2. These come with another $350K in machines necessary to create the Widgets.
  3. You have $1.4 million in 1031 exchange proceeds from your prior sale.
  4. Your lender will finance up to $1 million for the purchase of real estate.

 

You have $2.4 million in potential purchase funds and only $2.35 million worth of real estate and equipment. Let’s also say that your lender will only allocate loan proceeds to pay for the factory and warehouse.

Now you have a problem.

Per IRS rules, those Widget machines are NOT like-kind to real property. You can’t trade $350K of real estate for $350K of equipment and defer taxes. If you use 1031 proceeds to pay for the Widget machines, you’ll recognize personal property boot.

We would suggest that you pay for the machines with outside cash. If you could not do that, maybe the lender could be flexible.

As a last resort, you would divert 1031 proceeds and deal with the ensuing taxes.

Boot Offsets and Net Boot

Taxpayers only realize and pay taxes on Net Boot. That is to say that some boot items can be netted out by Boot Offsets, which are additional liabilities assumed by the taxpayer engaged in the 1031 Exchange.

In determining the amount of net boot received in a 1031 exchange, you should take great care to consult with your qualified intermediary and tax advisor.

The rules governing boot offsets are not fully explicit, and much legal and regulatory ink has been spilt on the subject.

(For reference, refer to IRC § 1.1031(b)-1 and § 1.1031(d)-2; also IRS Rev. Rul. 79-44)

If you have questions about potential boot items in your exchange, our 1031 experts can help.