Avoiding Boot
“Boot” in the context of a 1031 exchange refers to items of non “like-kind” property acquired as part of the exchange. While the receipt of boot does not disqualify the entire exchange, the fair market value of boot received in an exchange may be subject to tax. Common examples of boot include the following:
- Cash proceeds received by the Investor during the exchange. Often, an Investor will want to receive some cash as part of the exchange. If the Investor knows the amount of cash prior to closing, it is best to set up the exchange whereby this cash is paid to Investor at the closing of the Relinquished Property. Once the exchange proceeds are transferred to the Intermediary, the Investor may not elect to receive cash until the exchange has been completed.
- Proceeds taken from the exchange in the form of a promissory note. The only difference between cash and a promissory note is that an Investor can utilize the installment rules with respect to a seller carry-back note. This means that the tax associated with the note can be deferred over the term of the note (i.e. Investor pays tax on note proceeds as they are received).
- Other non like-kind property received in an exchange. For example, if the Investor receives personal property in an exchange of real property, the fair market value of the personal property received will be considered boot and subject to tax.
- Relief from debt on the Relinquished Property caused by the Investor utilizing all cash proceeds but acquiring Replacement Property that is of lesser value than the Relinquished Property. In other words, the Investor takes on less debt on the Replacement Property than the debt that was paid off in connection with the sale of the Relinquished Property. This is commonly referred to as “mortgage boot”. Mortgage boot can be offset by additional cash paid for the Replacement Property.
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Example 1: |
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Relinquished Property |
$200,000 $10,000 $100,000 |
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Replacement Property Purchase Price Exchange Proceeds New Debt |
$190,000 $90,000 $100,000 |
| Exchange Proceeds | $90,000 | |||
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| Result: No boot received since Investor has reinvested all Exchange Proceeds into Replacement Property of equal value to the net sales price of the Relinquished Property (i.e. sales price less Exchange Expenses). | ||||
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Example 2: |
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Relinquished Property |
$200,000 $10,000 $100,000 |
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Replacement Property Purchase Price Exchange Proceeds New Debt |
$180,000 $90,000 $90,000 |
| Exchange Proceeds | $90,000 | |||
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| Result: Investor has $10,000 of taxable boot since there has been a trade down in value from the Relinquished Property to the Replacement Property. The trade down is caused by Investor taking on $10,000 less debt on the Replacement Property. | ||||
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Example 3: |
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Relinquished Property |
$200,000 $10,000 $100,000 |
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Replacement Property Purchase Price Exchange Proceeds New Debt Additional Cash |
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| Exchange Proceeds | $90,000 | |||
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| Result: No boot. Even though Investor has taken on debt that is $10,000 less than the debt paid off on the sale of the Relinquished Property, the “mortgage boot” is offset by Investor paying an additional $10,000 towards the purchase price for the Replacement Property. In other words, Investor has offset the mortgage boot with additional cash paid. | ||||
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Example 4: |
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Relinquished Property |
$200,000 $10,000 $100,000 |
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Replacement Property Purchase Price Exchange Proceeds New Debt |
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| Exchange Proceeds | $90,000 | |||
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| Result: Investor has $10,000 of taxable cash boot since Investor utilized only $80,000 of the $90,000 of Exchange Proceeds. While an Investor can offset mortgage boot by paying additional cash, an Investor cannot offset cash boot with additional debt on the Replacement Property. | ||||
To avoid boot the Investor should follow these two simple rules.
- Purchase “like kind” Replacement Property or Replacement Properties that are of equal or greater value than the net sales price (i.e. sales price less “exchange expenses”) of the Relinquished Property; and
- Utilize all of the Exchange Proceeds from the sale of the Relinquished Property as a down payment towards the purchase of the Replacement Property.
