The main benefit of a 1031 exchange is to defer taxes on capital gains. In theory, you should be able to delay payments on all the proceeds of a real estate asset sale, but there are cases when you may still incur tax liability. One specific scenario is the 1031 exchange boot — money or non-like-kind property you receive during a like-kind swap.
The boot can be a significant issue that many investors want to minimize or avoid tax liability altogether. At Realized 1031, we’ve shared a guide to help you gain an in-depth understanding of the 1031 exchange boot. You’ll learn the specifics like how it arises, how to calculate it, and how to minimize or eliminate boot. Keep reading to learn more.
What Is 1031 Exchange Boot?
In general finance, boot is an amount people add to an exchange to match the value of the traded good. It’s a little different when it comes to real estate transactions, specifically 1031 exchanges. The boot is any amount or non-like-kind property you receive during the exchange. This amount is taxable, hence the important distinction. Boot generally happens when the property seller needs to make up the difference between the value of the relinquished property and the replacement property.
There are a few types of boot.
- Cash Boot: Cash boot is any leftover cash after acquiring the new property.
- Mortgage Boot: Also called mortgage relief, mortgage boot occurs when the mortgage debt of the acquired property is lower than that of the relinquished one.
- Personal Property Boot: Any profit from personal property you include during the exchange.
The IRS has strict rules regarding which types of proceeds can qualify for 1031 exchanges. Specifically, you can only defer income from real estate property. As such, boot becomes a significant tax liability and decreases the amount of income you can defer.
How Boot Arises in a Like-kind Exchange
There are several scenarios where boot can occur.
Cash Boot
If you exchange a property with another one that has a lower value, you’re left with cash. For example, a relinquished property is $1 million while the acquired property is $900,000. The cash boot is $100,000, and it’s taxable.
Mortgage Boot
Mortgage boot in 1031 exchanges occurs when you exchange a property that has higher mortgage debt than the acquired one. For example, property A and property B have the same value of $1 million, which makes them suitable candidates for a 1031 exchange. However, property A has $250,000 in mortgage while property B only has $200,000. If you acquire property B, you will be relieved of $50,000 in mortgage debt. This is considered boot and is taxable.
Personal Property Boot
Personal property boot is any non-real estate property received during the transaction. Let’s say you sold an apartment building at $1 million with $50,000 in furniture. You exchanged the apartment building for a $950,000 property. The remaining $50,000 is considered boot and is taxable.
How Is Boot Taxed in a 1031 Exchange?
The IRS taxes boot in two ways: ordinary income and capital gains. Learning how to calculate 1031 exchange boot for either classification helps you understand your expected tax liability.
In general, the federal and state revenue agencies classify boot as capital gains. In 2024, this means that the highest rate you may pay is 20%. For example, your relinquished property has a value of $1 million while the acquired property is $900,000. You receive a cash boot of $100,000. If you belong to the highest tax bracket, then $100,000 * 20% = $20,000. You will need to pay $20,000 in capital gains taxes.
There are certain scenarios where the IRS considers boot as ordinary income. In such cases, those in the highest tax bracket can expect up to 25% in tax rate. One common example is when you hold the property for less than a year. The capital gains you earn from the sale of the short-term investment property are taxable as ordinary income. By extension, the IRS will tax the boot from these transactions by up to 25%, depending on your tax bracket.
Personal property boot is also usually considered ordinary income. These proceeds aren’t part of the real estate asset, making them subject to ordinary income taxes. For example, you exchanged an industrial facility costing $1.5 million and $200,000 worth of specialized equipment. The IRS will tax the $200,000 boot, with you paying up to $50,000 in ordinary income tax.
Avoiding or Minimizing Boot in a 1031 Exchange
Wondering how to avoid mortgage boot in 1031 exchanges? Can you eliminate cash boot altogether? Here are some tips and best practices to follow to potentially minimize and possibly avoid boot and the attached tax liability.
- Match Property Values: Be sure to find a property that matches or has greater value than the property you’re about to relinquish. This helps you potentially avoid cash boot.
- Debt Replacement: Apart from finding a real estate asset that has similar value, you need to find one that has similar or higher mortgage debt.
- Reinvest Leftover Proceeds: You can use the leftover proceeds for other legitimate expenses during the 1031 exchange so you have little or no cash boot. These include the following.
- Qualified intermediary fees
- Real estate broker commissions
- Closing costs
- Engage With Your Qualified Intermediary: Engaging with a qualified intermediary is a required step in a 1031 exchange. This entity ensures that you adhere to the rules of the IRS. One other service they can provide is helping you identify which properties will allow you to defer all your capital gains and avoid boot.
Wrapping Up: The Basics of 1031 Exchange Boot
The promise of complete tax deferral for your capital gains in a like-kind swap is appealing, but you need to watch out for hidden risks like the 1031 exchange boot. This type of taxable income is any amount you receive from non-like-kind property, disqualifying it from the tax-deferred status. Examples are cash boot, mortgage relief, and personal property boot. Failure to account for boot can lower the amount you can defer.
If you want to learn more about 1031 exchange boot and the strategies to avoid it, we can help. Contact Realized 1031 today to schedule a consultation.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.leaderbank.com/blog/what-boot-1031-exchanges
https://www.investopedia.com/terms/b/boot.asp
https://www.kiplinger.com/real-estate/boot-in-a-1031-exchange-how-to-minimize-tax-implications
