1031 exchanges allow investors to defer capital gains tax on their real estate sale proceeds. Instead of simply selling your property for capital assets, you take the proceeds from your sale and reinvest them into a replacement property.
If you don’t reinvest all your profits, boot is formed. Boot is subject to taxes immediately, and you should take steps to avoid developing boot in your 1031 exchange.
What Is a ‘Boot’?
In the investment world, the term ‘boot’ is used to describe the value of cash or non-like-kind property that you receive in an exchange of your assets. The exchanges must be of fair value. Non-like-kind property may include forms of debt relief, installment notes, or any other exchange that is not considered like-kind property.
Some examples of boot are:
- Cash profits from the exchange of properties
- Debt relief or mortgage reduction when property is exchanged
- When real property is exchanged for personal property
- When proceeds from the exchange are used to cover non-closing costs or other non-transaction costs such as building maintenance or property management
- If the replacement property in your exchange is not like-kind or includes other valuable assets or investment interests, such as an art collection
How ‘Boot’ Is Developed in a 1031 Exchange
In a 1031 exchange, boot is the amount of proceeds you don’t reinvest in a replacement property. For example, you may sell a property for $500,000 and buy a replacement property for only $400,000. The $100,000 difference is boot.
● Cash boot
Cash boot happens when you don’t use all the proceeds from the sale of your property toward the investment in your replacement property, causing money to be returned to you.
Cash boot can also occur if you don’t transfer all the proceeds from the sale of your property to your Qualified Intermediary (QI). Your QI is an independent party that facilitates your 1031 exchange.
● Mortgage boot
Mortgage and other debt reductions through 1031 exchanges also create boot. If the debt from your replacement property is less than the debt on the property you’re relinquishing, boot is created. Debt reductions create boot even if you use all proceeds from the sale of your property to purchase your replacement property.
Boot is also formed when you over-finance the mortgage on your replacement property. This happens when the mortgage from your relinquished property is higher than the mortgage of your replacement property. Boot is created in this instance even if the two properties are of the same value, you use all your proceeds to purchase the replacement property, and you send your QI all the proceeds from the sale.
Implications of Not Reinvesting Boot
If you don’t reinvest boot, you will be subject to paying capital gains taxes. These taxes are on profits made from the sale of your capital assets, including real estate and other investments.
Capital gains are taxed by the federal government and through many state taxes. Your federal capital gains tax rate depends on your income level and ranges from state to state.
To avoid paying this tax, consider reinvesting your boot by purchasing additional properties or buying replacement properties that have higher values than the property you’re relinquishing.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. Cash flow or income are not guaranteed.
