Although not specifically defined (or even mentioned in IRC Section 1031), the term “Boot” is a vernacular term and used frequently. It refers to the fair market value of cash, benefits, or other non “like-kind” property that a taxpayer receives in an exchange, and which is subject to capital gains tax. The determination of 1031 exchange boot can be tricky, because it can include any item in an exchange that is not considered like-kind as defined under IRC Section 1031.
It’s important to note that investors involved in a 1031 exchange should always consult with their independent tax counsel and qualified intermediary (QI) before and during the closing process on both their relinquished property and replacement property.
1031 boot can arise in several forms, but the following are the most common:
- Cash boot
- Mortgage (or debt) boot
- Personal property boot
Let’s go over each one.
Cash boot is defined as “net cash received” at the closing of the relinquished property or the replacement property. Cash equivalents, such as a promissory note, are included in the calculation of net cash received, as are other common items found on the closing statements (more on that shortly).
Cash and cash equivalents are not considered like-kind, and therefore subject to capital gains tax, even though the majority of the exchange value may be eligible for capital gains tax deferral. Some common sources of cash boot to watch out for include:
- A promissory note from a buyer: In general, the principal amount of these notes are subject to capital gains tax, while the interest would be taxable as regular income.
- Rent prorations, tenant security deposits, repair and maintenance charges: Any service costs or closing prorations, which are not actual closing expenses, are considered cash boot. For this reason, when executing an exchange, investors should carefully review each closing statement in advance with their advisors and qualified intermediaries so they are prepared to bring cash to the closing to handle these items.
- Excess borrowing: If you borrow more than what is necessary to close on a replacement property, the excess funds will be left over in your qualified intermediary’s account after the exchange is complete. The QI will distribute these excess funds to you, and it will be taxable as cash boot.
Mortgage (or Debt) Boot
Mortgage boot arises when the mortgage debt on the property being purchased (a.k.a., the replacement property) is less than the mortgage debt outstanding on the relinquished property at the time it was sold. For this reason, it’s important that investors ensure that the mortgage debt on the property being purchased equals or exceeds the mortgage debt on the property being sold. If not, the difference will be subject to capital gains tax on the exchange.
Personal Property Boot
Personal Property Boot, although less common, still warrants careful consideration when executing an exchange. This type of boot results when the sale or purchase of an investment property also includes assets other than real estate. Appliances, equipment, inventory, and any other non-real estate assets included in either the purchase or sale can result in a capital gains tax liability. For this reason, investors executing a 1031 exchange will want to plan ahead and work with the buyer/seller to handle these items separately.
Tips to Avoid Boot
The handling for closing costs, exchange expenses, financing costs and prorations in a tax deferred exchange can be complex, which is why it’s no surprise that most investors find them confusing. But we can offer a few good tips on how to avoid boot in an exchange, and thereby avoid paying any capital gains taxes associated with the transaction:
- Always trade up in the value of real estate, which also includes the amount of mortgage debt the real estate carries.
- Be prepared to bring cash to the closing, or work with the buyer/seller to have prepaid items and prorations deposited into escrow prior to closing.
- Do not receive any property that is not like-kind. Handle items such as equipment and inventory in separate transactions.
- Don’t over finance your replacement property.
Always have your closing statements reviewed by your tax professional and qualified intermediary before you close to identify potential sources of boot. Professional advisors can suggest changes in the closing procedure and schedule to minimize taxable impacts.
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