If you're completing a 1031 exchange, the key factor that determines if you'll pay any taxes is a concept called boot. In this discussion, we'll learn what boot is in a 1031 exchange and why it matters to you as an investor.
A 1031 exchange can be a rental property investor's best friend. Instead of getting hit with a hefty capital gains tax bill upon the profitable sale of an investment property, a 1031 exchange allows you to roll the sale proceeds into a new property and defer tax liability indefinitely. However, not all 1031 exchanges are tax-free, to understand why, you need to understand how boot works.
Is your 1031 exchange completely tax-free?
There are two important conditions real estate investors need to meet if they want a 1031 exchange to be completely free of tax liability.
First, the value of the property being bought (the replacement property) must be equal to or greater than the net sale price of the property being sold (the original or relinquished property). So if you sell an investment property for $500,000 and buy a replacement property for $600,000, it would meet this requirement.
Second, the amount of debt taken on with the replacement property must be equal to or greater than the original property's outstanding debt at the time of the sale. In other words, you can't reduce your debt as a result of a 1031 exchange if you want the transaction to be entirely tax-free. For example, if you sell a property and had a $200,000 mortgage balance at the time of the sale, your replacement property would need to have debt greater than or equal to this amount.
What if you don't meet both requirements?
To be perfectly clear, you can still do a 1031 exchange that doesn't meet both of these requirements -- it just won't be completely tax-free. In other words, a 1031 exchange isn't necessarily an all-or-none transaction. You can avoid taxes on some of your profits on the sale of an investment property by rolling some (but not all) of the proceeds into a new property, a process known as a partial 1031 exchange.
If you receive cash from the sale of your original property or buy a replacement property with a lower debt level, the difference is known as boot (or taxable boot) and is taxable to the extent of the capital gain you realized on the exchange.
To be clear, you can receive :
- Cash boot: Cash received upon the closing of either the original or replacement properties. For example, if you own a property with no mortgage, sell it for $300,000, and buy a new property for $250,000.
- Debt reduction boot: Occurs if you finance less debt in the process of acquiring the replacement property. This is also known as mortgage boot. As an example, if you sell a property for $500,000 with a $300,000 mortgage balance and buy another property for $400,000 with a $200,000 mortgage, you will have received debt reduction boot even though you rolled all of your equity into the new property.
It can also be considered boot if sale proceeds from the original property are used to pay for anything that isn't a transaction cost. Rent prorations are a good example, as are damage deposits from tenants that you transfer to the original property's buyer. Your 1031 exchange facilitator can tell you if you need to bring cash to the closing to cover any of these costs.
It's also important to mention that the IRS only taxes net boot that the taxpayer received in a 1031 exchange. In other words, if you reduce your debt at closing but pay more cash out of pocket, you can avoid having taxable boot. For example, if you sell a property for $500,000 with a $300,000 mortgage and buy a property for $500,000 with a $200,000 mortgage, the additional $100,000 in cash you'll have to contribute will offset the debt reduction boot you receive.
Is boot ever worth it?
There are certainly some situations where receiving boot in a 1031 exchange can be worthwhile. For example, if you sell an investment property and could use a small portion of the proceeds to cover living expenses, it can be smart to do a partial 1031 exchange and receive (and pay tax on) the desired amount of cash at the closing.
The bottom line on boot
If you don't want to pay any tax on your 1031 exchange, here's what you have to do:
- Don't take any cash out of the property you're selling, or at the closing of your new investment property. Your 1031 exchange funds must all be reinvested.
- If you have a mortgage when you sell the original property, obtain a mortgage on the new property that's at least the same principal amount unless you plan to contribute cash out-of-pocket to make up the difference.
- If there are any non-transaction costs you have to pay, be sure to cover them with cash, not with proceeds from the original property's sale.
Since you'll need a 1031 exchange facilitator or qualified intermediary to set up the exchange, this professional can help you avoid receiving any type of boot if your intention is a completely tax-free transaction.
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