You may use a 1031 Exchange investment strategy to defer capital gains and retain your wealth when selling investment properties. 1031 or like-kind exchanges allow you to use the gains from the sale of your property or asset to reinvest in another similar property and defer capital gains tax liability.
However, if you don’t reinvest all the proceeds, it can result in an exchange boot and accompanying capital gains taxes. Learn more about exchange boots in 1031 Exchanges and how to ensure you don’t owe capital gains taxes after your property swap.
What is an Exchange Boot?
An exchange boot refers to funds you receive from the exchange of like-kind property over and above the original asset’s value. In a 1031 Exchange, investors must use all gains made from the sale of a property to reinvest.
If you receive additional funds or cash value items, it forms a boot, which can affect your tax liability on the sale. The following are examples of exchange boots:
- Debt relief
- Mortgage reduction
- Cash profits
- Exchange of real property for personal property
- Additional assets of value
- Using funds for non-transactions costs
Cash vs. Mortgage Boot in a 1031 Exchange
Two types of boots can result from a 1031 Exchange: cash and mortgage boots.
- Cash Boots
Cash boots also happen if you fail to transfer the gains to the Qualified Intermediary who facilitated your exchange.
- Mortgage Boots
Mortgage boots happen when an uneven 1031 Exchange results in a mortgage or debt reduction. For example, the mortgage you owe on the replacement property is less than the mortgage you owe on the original property. If this occurs, it reduces your overall debt, creating a mortgage boot, even if you used all your sale proceeds to purchase the like-kind asset.
A mortgage boot can also occur if you obtain too much financing for the replacement property. An over-financed mortgage on the replacement property that is higher than the old property’s mortgage creates a boot, despite following all other rules of a 1031 Exchange.
How to Avoid Boots in a Like-Kind Exchange
You can take several steps to minimize the risk of forming a boot during a 1031 Exchange. First, work closely with an experienced financial planner or accountant to assist you with the transaction. A professional can ensure you don’t miss deadlines or choose non-like-kind assets that could result in a boot.
Reinvest the capital you earn on selling your investment property for a 1031 Exchange. Failure to reinvest your proceeds disqualifies the exchange and results in a capital gains tax liability for the sale.
When making a 1031 Exchange, consider all aspects of the deal. Verify that neither mortgage is higher than the other and that you won’t receive any cash-value assets that would result in a cash boot. In some cases, you may be able to offset a mortgage boot with cash; however, it doesn’t work the other way around.
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.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
