Like Kind Exchange — Examples of “Boot”

It’s not uncommon to throw around terms like “cash boot” or “mortgage boot” in a 1031 like-kind exchange.

But what exactly is “boot”?

You won’t find that word in the Internal Revenue Code (IRC). It does not appear in the Treasury Regulations.

Here, “boot” means value “given in addition to.” The term is common in car trades. When a new car trades for an old car, the owner of the old car often brings extra money (boot) to even out the trade.

We go over some easy examples so you can see how it applies in a 1031. 

1031 Boot: Cash vs. Mortgage

Here’s a simple definition:

Boot in a 1031 exchange is anything received by the seller that is not like-kind property.

Of course, it’s often deeper and more complex than that. But this is a good starting point. Regulators designed section 1031 to promote further investment, so they want to tax any value not exchanged into another investment property.

Let’s take a simple example.

Sean’s relinquished property – $300,000

Tax basis – $200,000
____________________________

Sean’s replacement property – $260,000

(Assume Sean owns his relinquished property free and clear.)

Here, Sean faces a capital gain of $100,000 (sale price – basis). Unfortunately, he trades down in value by $40,000 (the difference between relinquished and replacement). 

The way the IRS sees things, Sean traded a $300K asset for a $260K asset plus $40K in cash. Cash is not like-kind to real property, so Sean can only defer $60,000 of his capital gain ($100K – $40K in boot). 

That $40K in net cash received by Sean represents cash boot.

Cash boot

Net cash received is the most obvious kind of cash boot. 

You will also trigger cash boot if you take cash directly from your sale. Here’s another quick example.

Jen’s relinquished property – $300,000

Tax Basis – $200,000

Cash proceeds taken at closing – $10,000
____________________________

Jen’s replacement property – $325,000

Here, Jen took out $10,000 from her sale to pay off credit card debt. Since that $10K did not go into the 1031 escrow account to buy replacement property, it became fully taxable.

It does not matter that Jen bought a more valuable replacement property ($325K vs $300K). The $10,000 is cash boot and now Jen can only defer $90,000 of her capital gain ($100K – $10K in boot).

Now, a clever investor might ask “What if Jen brought another $10K in outside funds to the replacement closing?” 

No dice. Jen still recognizes $10K in cash boot. 

Cash equivalents

Other items considered “cash equivalents” will be taxable as cash boot in a 1031 exchange, including

  •  Rent prorations
  •  Repair and maintenance expenses
  •  Tenant deposits
  •  Promissory note from a buyer (interest taxable as regular income)

Mortgage boot

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

But here’s the thing:

Mortgage boot is very simple. Taxpayers realize mortgage boot in a 1031 exchange to the extent that they fail to fully replace the value of debt on their relinquished property. 

Let’s look at an example with an LLC as exchanger. 

For the Birds LLC’s relinquished property – $650,000

Tax basis – $350,000

Debt owed – $200,000

Equity – $450,000
____________________________

For the Birds LLC’s replacement property – $575,000

1031 proceeds as down payment – $450,000

New debt – $125,000

Here, For the Birds LLC faces $300,000 in capital gain (sale value minus basis). And, it will not incur any cash boot. After all, 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 $650K asset for a $575K asset plus $75K in debt relief (mortgage boot). Debt relief is not like-kind to real property. 

So this LLC can only defer $225K of its capital gain ($300K – 75K in boot). 

(Myth) You need to trade equal or up in debt to avoid mortgage boot

Many resources — even those from so-called 1031 “experts” — get this part wrong. 

People like to shorthand the rules around mortgage boot by saying “You have to trade equal or up in debt” to defer all taxes. In other words, they claim that the mortgage on your replacement property must be as large or larger than the mortgage on your relinquished property. 

This is not true. 

Yes, trading into a property with a larger mortgage does avoid mortgage boot. But remember you must simply replace the value of your old debt. This means you can deleverage by bringing outside cash to make up the difference. 

Take this example:

For the Birds LLC’s relinquished property – $650,000

Tax basis – $350,000

Debt owed – $200,000

Equity – $450,000
____________________________

For the Birds LLC’s replacement property – $685,000

1031 proceeds as down payment – $450,000

New debt – $125,000

Outside cash – $110,000

Here, For the Birds LLC still deleverages by $75,000, still realizes $300,000 in capital gain, and transfers all net equity (avoiding cash boot).

Except now the LLC fully replaced the value of its old mortgage debt of $200,000. The LLC does this with a combined $235,000 in new debt and 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.

Bonus — Personal property 

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 this example:

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

That’s $2.4 million in potential purchase funds and only $2.35 million worth of real estate and equipment. Let’s say 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. 

Avoiding Boot, Boot Offsets, and “Net Boot”

Want to make sure you avoid boot, regardless of the type?

We have good news for you. By following a few simple rules, you can avoid most major boot items. 

Beyond these, work closely with your qualified intermediary and tax advisor to circumvent more insidious, annoying traps.

First, we’ll cover the simple rules.

Trade equal or up in net equity and value

Consider two like-kind exchange rules.

  • Rule One: A taxpayer must trade equal or up in net equity from relinquished property to the replacement property.
  • Rule Two: A taxpayer must trade equal or up in net sales price from relinquished property to the replacement property.

You must comply with both rules to receive full tax deferral. The 1031 industry commonly refers to these as the “equal or up in equity” and “equal or up in value” rules.

But we can restate these rules to make them more simple.

  • Simple Rule One: Transfer all of your net proceeds to the replacement property via a 1031 escrow account. 
  • Simple Rule Two: Buy a property that is as valuable as what you sold.

If you violate Rule One, you’ll recognize cash boot and owe taxes.

If you violate Rule Two, you’ll recognize mortgage boot and owe taxes. 

Here’s one more simple example to drill this home. Here, Dr. John Watson plans to sell a $2 million asset but doesn’t yet know what he needs to buy in order to defer all of his taxes. 

Dr. Watson’s relinquished property – $2,000,000

Tax Basis – $1,500,000

Debt owed – $1,050,000

Equity – $950,000
____________________________

Dr. Watson’s Replacement property – ?

Following our Rule Two, Dr. Watson knows that he must buy property (or properties) with a net sales price of at least $2 million. Suppose he finds a great building on the market for $1.75 million. 

Clearly, this building doesn’t satisfy the second rule. 

After speaking with his QI and his broker, he decides to buy the adjacent plot for $500,000. Now his two purchases, worth $2.25 million, qualify for full tax deferral. 

He must also satisfy Rule One and put all $950,000 in net equity into the new properties. Dr. Watson can divide the down payments however he sees fit between the two replacement assets.

(Disclaimer: In reality, closing costs would reduce both the net sales price and net equity for the Doctor. Supposing $50K in closing costs, Rule One would require a combined down payment of $900K and Rule Two would require replacement properties worth at least $1.95M for full deferral.)

You only get taxed on “net boot”

To make this a bit more confusing, the IRS won’t tax you on all boot items. Instead, you’ll only face taxes on net boot

At first, net boot seems simple enough. 

If you relieve yourself of certain financial liabilities in an exchange (e.g. paying off debt), but also assume certain liabilities — “boot offsets” — (e.g. assuming new debt or paying additional cash), you only have to pay taxes on the difference. 

We saw an example of boot offsets earlier. For the Birds LLC brought outside cash to its replacement property, which “offset” the relief received by deleveraging.

Unfortunately, the application of net boot in a 1031 exchange often ventures into the obscure. Indeed, a thorough investigation would introduce too many concepts to explore fully in this article. 

So why bring it up? There are two common cases worth highlighting.

  1. YOU CANNOT ever offset cash taken from the relinquished closing by assuming more debt or bringing outside cash to the replacement closing. 
  2. YOU CAN sometimes offset cash received by paying for certain exchange expenses out of pocket. The classic example is a reimbursement of earnest money deposit on the replacement property. 

Get the Most Out of Your Next 1031 Exchange

We hope this post helped clarify things for you.

Now it’s time to maximize your tax savings.

So how do you do that?

That’s easy.

Contact our staff here or call 303-504-0144.

By |2019-09-10T23:04:51-06:00August 25th, 2019|1031 Exchanges|