Real estate investors have used 1031 exchanges for decades to defer capital gains tax liabilities generated from the sale of investment properties.
In order to fully defer capital gains taxes on any realized gains, investors must roll over the entirety of the sale proceeds from their relinquished assets. Any funds that aren’t reinvested are considered “boot” and are taxable.
Let’s take a closer look at cash and mortgage boot and discuss how they can be generated during a 1031 exchange.
For some investors, the whole point behind a 1031 exchange is to defer capital gains taxes (some investors complete 1031 exchanges to “trade up” assets, or to diversify their portfolios by exchanging into assets in different geographical regions). Receiving cash out of the exchange – reinvesting only $900,000 on a $1 million sale, for instance, generates a capital gains tax liability on the $100,000 of sale proceeds that weren’t rolled over into the replacement asset.
Depending on your income and tax filing status, you would have to pay long-term capital gains tax of 0, 15, or 20 percent on the cash boot taken out of the exchange.
|
Long-term capital gains tax rate |
Cash Boot |
Tax liability |
|
0% |
$100,000 |
$0 |
|
15% |
$100,000 |
$15,000 |
|
20% |
$100,000 |
$20,000 |
Depending on how long you held the asset, your tax burden could be even higher. Short-term capital gains are considered ordinary income and are taxed at your marginal tax rate, which could be as high as 37 percent.
If you do take cash out of your 1031 exchange at the close of sale on your relinquished property, you can replace it with cash boot paid during the closing on your replacement asset. However, any net cash boot received will always generate a taxable event.
You don’t have to take cash proceeds out of a 1031 exchange to generate boot. If the debt on the replacement asset is less than the debt on the relinquished property, you will generate mortgage boot during the exchange.
Here’s an example: Your relinquished asset sold for $1 million, and you had a $250,000 mortgage that was paid off at close of sale. You rolled the entirety of the sale proceeds into a replacement asset, but the mortgage on your replacement property was only $200,000. The $50,000 difference is subject to capital gains tax.
Exchangors who swap properties with unequal mortgage debt can avoid taxation by bringing additional cash to the closing table. It’s important to note that you can add cash to an exchange to offset mortgage debt; however, you can’t use additional debt to offset any cash taken from the exchange.
Avoiding mortgage or cash boot during a 1031 exchange is fairly simple – roll the entirety of sale proceeds over into a like-kind replacement asset, and swap an equal or greater amount of debt.
Exchangors should always seek to trade up or straight across and never down, since doing so will typically result in cash boot, debt reduction, or both, and will generate a taxable event. In instances where cash is taken from the exchange, you can bring additional cash to the closing table on your replacement asset to “square up” exchange funds. You also can bring cash to the closing table to supplement any reduction in mortgage debt during the close of sale on your replacement property.
Consulting with a Qualified Intermediary about equity and debt requirements on replacement properties prior to undergoing a 1031 exchange can help investors better understand the amounts required to fully satisfy exchange requirements and avoid generating cash or mortgage boot.