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Boot In A 1031 Exchange

July 19, 2023

Not all 1031 exchanges follow the process of selling the relinquished property and acquiring a replacement “like-kind” property; that’s where the concept of boot comes into play. In this article, we will define and explain concept of boot in a 1031 Exchange. If you’re wondering what is a boot, and what does it have to do with a 1031 exchange, you’ve come to the right place. By the end of this article, you’ll be equipped with everything you need to know.

What is a boot in a 1031 Exchange?

What is a boot in a 1031 Exchange?

A boot is any portion of the proceeds after selling a relinquished property that is not reinvested in the replacement property. This portion is susceptible to tax consequences.

To effectively defer capital gains taxes in a 1031 exchange, all the proceeds from selling the relinquished property should be reinvested in the replacement “like-kind” property. Any excess cash amount of the cash proceeds that is not reinvested is referred to as a boot.

There are different types of boots in a 1031 exchange.

Cash boot:

This is the amount received by an investor when the replacement property value is lower than the relinquished property value, or when an investor decides to hold back some cash from the proceeds of the relinquished property.

Mortgage boot:

Mortgage boot

This occurs when an investor takes on a lower mortgage debt on the replacement property compared to the relinquished property mortgage debt. The difference in the debt is subject to tax liability.

Non-“Like-kind” property:

This is a property that does not meet the requirements of being “like-kind” in a 1031 exchange. A non qualified property can include art, furniture, appliances, and real estate partnership interests.

Personal property boot:

In some scenarios, real estate transactions can involve personal property like appliances and furniture that usually come with the . Personal property does not count as “like-kind” property and is subject to taxable gain in a 1031 exchange.

Non-transaction costs:

Any transactional costs that an investor deducts from the sales proceeds to facilitate the exchange process are subject to tax liability. Some of these costs include legal fees, escrow fees, professional services, or any other buyer outstanding bills for maintenance or repairs.

Boot in Reverse 1031 Exchanges

Boot in Reverse 1031 Exchanges

A reverse 1031 exchange is when an investor acquires the replacement property before selling the relinquished property. A boot in a reverse 1031 exchange occurs when the value of the replacement property is less than the value of the investor’s property before being relinquished. The excess amount is subject to tax consequences.

How is Boot taxed?

A 1031 exchange aims to delay paying capital gains taxes by reinvesting the money from the sale proceeds of a relinquished property in a “like-kind” replacement property. However, it works differently when boots are involved. The tax liability of a boot, also known as a taxable boot, depends on the type of boot and its value.

Calculating the tax liability associated with boot

To calculate the tax liability associated with a certain boot, you must first go through a few steps to understand the type of boot received and its value. Here is a breakdown of the process.

Identify the type of boot:

Understand the type of boot you received. Is it a cash boot, a mortgage boot, personal property, non-transaction costs, or a non-like-kind property?

Determine the fair market value of the boot.

The fair market value is the difference between the like-kind property exchanged and the non-like-kind boot received. It is important to hire the services of a qualified professional to help you determine the fair market value.

Calculate the taxable gain:

To calculate the taxable gain, subtract the original purchase price of the relinquished property from the fair market value of the boot. The difference is the taxable gain.

Apply the appropriate tax rate:

The tax rate is determined by the type of boot received and the investor’s income tax bracket. Both cash and mortgage boot are subject to capital gains taxes, while personal property boot is subject to ordinary income tax. Once you identify the appropriate tax rate you can easily calculate the tax liability due.

Calculate your tax obligation:

Calculate your tax obligation

An investor’s tax obligation is the sum of the taxes due on the taxable gain from the investment.

It is important to understand that the taxable boot is different from the tax deferral benefits of a 1031 exchange.

Understanding the concept of “basis” in boot transactions

“Basis” in real estate transactions can be defined as the price of a property for tax purposes. It’s also referred to as the original purchase price of an asset. In real estate transactions, “basis” is used as a reference point to calculate profit or loss in an exchange or transaction.

It is also used to help calculate potential boot amount of a 1031 exchange.

Case studies: Navigating different types of boots in a 1031 exchange

Cash boot

John, a seasoned real estate investor, owns a commercial property and is looking to diversify his portfolio. He decides to sell his commercial property and acquire two commercial properties through a 1031 exchange. He sells his commercial property for $300,000 and acquires two replacement properties, both valued at $200,000. He now incurs a cash boot valued at $100,000. John decides to seek the services of a qualified intermediary to help him accurately report the additional cash from the boot and associated taxable gain, depending on his income bracket, on his tax filings.

Mortgage boot

Jane is a real estate investor who decides to sell her residential apartments and acquire residential apartments in a different location. She has a mortgage on her current relinquished property for $100,000. She sells the relinquished property for $250,000. The QI holds the proceeds left after paying up the mortgage debt. She finds a replacement that fits the “like-kind” criteria and is valued at $250,000.

Since she is not in a position to fully finance the new property. She assumes a new mortgage worth $80,000 to finance the replacement property. By doing this, she creates a debt reduction boot. The difference in the mortgage amount is now subject to tax liability. She decides to hire the services of a QI to help her navigate the intricacies of a mortgage, how to go about calculating the tax liability, and how she can pay off the taxes due.

Strategies to Minimize or Avoid Boot in a 1031 Exchange

Strategies to Minimize or Avoid Boot in a 1031 Exchange

The main objective of an investor using a 1031 exchange for real estate business or investment purposes is to have a fully tax-deferred exchange. That means that an investor can defer taxes until a future taxable event. When it comes to 1031 exchange transactions, boot scenarios occur regularly.

So how do you minimize or potentially avoid the boot in a 1031 exchange?

To meet your investment objectives? There are a few rules of thumb an investor needs to follow to prevent boot.

The first rule is always to trade up or across in a 1031 exchange. Acquire property that is of equal or greater value. Do not trade down, that is, acquiring a replacement property of less value than the relinquished property, because that instantly yields a cash boot.

One way to mitigate cash boot when you purchase a replacement property of less value than the relinquished property, is to have an exchange of the cash boot with the expenses incurred during the 1031 exchange transaction.

Avoid identifying non-like-kind” property in a 1031 exchange. To completely avoid scenarios of boot in a 1031 exchange, make sure the replacement property is “like-kind” to the relinquished property.

Cover all the transaction costs of a 1031 exchange separately. Avoid using the sale proceeds from the relinquished property to prevent incurring non-transactional taxable boot.

Do not overfinance a replacement property. Limit the financing to the amount required to close on the replacement property and the transactional costs incurred in the process.

Alternative ways to minimize boot

Aside from the rule of thumb, other ways you can ensure you minimize boot are to identify potential sources of boot in your 1031 exchange transaction before the exchange. This move helps you mitigate the boot early on in the exchange process.

Allocating costs and expenses between the replacement property and the relinquished property early on can help you manage boot or potentially avoid it.

Another way to minimize boot is to explore 1031 exchange alternatives. 1031 exchange alternatives would be more suitable for an investor who is likely to incur boot in a 1031 exchange and can potentially help them differ in capital gains taxes and fulfill their investment objectives.

If you are not well conversant with 1031 exchanges, you must hire the services of a qualified intermediary to help you have a successful 1031 exchange with zero boot.

Common Pitfalls to Avoid

One of the most common mistakes investors make is failing to involve a qualified intermediary from the start. A qualified intermediary helps you navigate the 1031 exchange seamlessly and avoid any setbacks during the process. Always seek out a qualified intermediary any time you are dealing with a 1031 exchange transaction.

Another pitfall is the inaccurate property valuation of both the replacement property and the relinquished property. This is usually quite detrimental since it leads to inaccurate boot amounts calculations.

Poor planning and preparation for the transaction is another setback that can ultimately cost the investor so much time and money. It is important to plan adequately before the transaction, identify possible sources of risk, and know how to mitigate them. Also, consult with various qualified professionals to get an overview of the whole transaction.

Failing to adhere to the IRS-defined timeframes in a 1031 exchange is another setback. It is important to identify the replacement property within the set time frame to have a successful 1031 exchange.

The Role of Professional Assistance in Boot Management

At Universal Pacific 1031 exchange, we have seen firsthand how having a professional by your side, especially a qualified intermediary, helps in a seamless 1031 exchange process and managing the exchange.

What does a Qualified Intermediary do?

A QI provides expert guidance on how to maneuver the boot in a 1031 exchange transaction. QIs are well-versed in tax laws, IRS rules, and boot management techniques.

When it comes to the 1031 exchange process, qualified intermediaries guide investors in structuring the exchange to reduce or eliminate boot. They help investors in finding replacement properties of equal or greater value to prevent cash boot.

QI advises investors on how to balance debt and equity between the properties that are given up and those that are replaced to handle mortgage boot concerns.

One of the primary responsibilities of QIs is facilitating the secure exchange of the sale proceeds to acquire the replacement property. They establish a segregated account to hold the funds during the exchange process. The QI makes sure that exchange revenues are wisely invested, which lowers the possibility of a cash boot.

All types of boot, such as cash boot, mortgage boot, or personal property boot, are identified and managed with the help of a QI. They assist investors in precisely estimating probable boot amounts, figuring out tax repercussions, and creating plans to minimize boot whenever possible.

Summary

The concept of boot, which has significant tax repercussions, is important to understand. Cash received, mortgage discrepancies, non-like-kind property, non-transaction fees, and personal property are all examples of this.

Inadequate preparation, incorrect property assessment, missing property identification deadlines, improper handling of exchange revenues, noncompliance with IRS laws, and a lack of expert counsel are common issues to avoid.

Using a competent intermediary is critical for boot management in a 1031 exchange transaction. They offer experienced advice, maintain IRS compliance, handle exchange revenues safely, and have experience recognizing and managing various sorts of boot.

If you are considering a 1031 exchange and have concerns about potential boot issues, it is crucial to seek professional guidance. Universal Pacific 1031 Exchange offers comprehensive solutions and expert advice to ensure a successful exchange while minimizing fees. Contact us today to schedule a consultation and experience the benefits of working with a trusted partner in your 1031 exchange journey.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.