Boot in a 1031 exchange can be created in several different ways, such as receiving cash, debt relief, or including personal property in your tax-deferred exchange.
While boot doesn’t cancel your 1031 exchange, it can create a surprisingly large tax liability. In this article, we’ll explain how boot is created and how you can easily avoid paying capital gains tax on boot by buying multiple replacement properties.
What is Boot in a 1031 Exchange?
Boot is a portion of the sales proceeds you receive from a 1031 exchange that isn’t re-invested in a replacement property. For example, if you sell a property for $200,000 but only re-invest $180,000, the $20K difference is known as boot.
The main reason for conducting a 1031 exchange is to defer the payment of capital gains tax. But, when you receive boot the exact opposite occurs because the boot is subject to capital gains tax. So, while the $180,000 has taxes deferred, the $20,000 is taxable when it is received.
How Boot in a 1031 Exchange Happens
The above example is a simple explanation of how boot in a 1031 exchange can happen. However, there are also ways that boot can occur, either on purpose or by accident.
Let’s take a look at the different factors that can create boot, to avoid an unpleasant surprise come tax time.
1. Cash proceeds
There are two ways cash boot received during a 1031 exchange can occur:
- Holding cash back by not transferring 100% of the sales proceeds from your relinquished property (the property sold) to your Qualified Intermediary (QI)
- Not using 100% of your sales proceeds from your relinquished property to purchase your replacement property, which causes cash to be returned to you when the 1031 exchange is complete
Mortgage or debt reduction can also create boot when conducting a 1031 exchange, even if you don’t actually receive cash back:
- Debt on the replacement property is less than the current debt on the relinquished property. For example, if the mortgage on your replacement property is only $90,000 while the mortgage on your relinquished property was $100,000 then $10,000 in debt reduction boot is created even if you use 100% of your sales proceeds to purchase your replacement property
- Excess borrowing can end up creating cash boot. Let’s say your relinquished property and replacement property both have a market value of $200,000 and you transfer 100% of your sales process to your QI. Fine so far, but if your relinquished property has a debt of $90,000 and the new mortgage on your replacement property is $100,000 you will have $10,000 in taxable cash boot returned to you when the 1031 exchange closes because you over financed the replacement property.
Sales proceeds in a 1031 exchange that are used to service non-transaction costs or non-closing expenses also result in taxable boot:
- Prorated rent
- Tenant security deposits transferred to the buyer
- Outstanding bills for repair and maintenance, or property management services
These items are taxable because the IRS acts as if you received cash from the 1031 exchange then turned around and used that cash to pay the expenses. To avoid boot being created with non-transaction costs you can bring extra funds to the closing table.
4. Non-like-kind property
Including non-qualified property, or property that is not “like-kind” in a 1031 tax-deferred exchange will also create boot. For example, buying a replacement property that includes the seller’s valuable art collection or combining real estate with a real estate partnership interest are both examples of how non-qualified property can create taxable boot.
5. Personal property
Appliances, equipment and supplies, and furnishings can also create boot because they are considered to be personal property instead of real property.
To avoid this, you can work with the seller to structure the purchase contract in such a way that appliances and any “extras” are included in the sale price of the real estate at no additional cost.
Two Examples of Boot
Two of the most common types of boot are cash boot and mortgage boot. Here’s how each can occur:
1. Cash boot
- Relinquished property value = $200,000
- Replacement property value = $225,000
- Cash taken at closing of relinquished property = $10,000
In this example, $10K was taken out of the 1031 exchange when the relinquished property was sold. Even though the value of the replacement property is greater than the relinquished property, the $10,000 is still subject to capital gains tax of up to 20%, depending on your income bracket.
Could you bring $10,000 to the closing table when you purchase the replacement property to ‘offset’ the cash taken out when the relinquished property was sold? According to the IRS, the answer is ‘No’ because the money is treated as cash boot.
2. Mortgage boot
Mortgage boot is a little bit trickier and also creates a potentially larger amount of boot that is subject to capital gains tax if you’re not careful:
Relinquished property
- Property value = $200,000
- Mortgage balance = $100,000
- 1031 proceeds held by QI = $100,000
Replacement property
- Property value = $200,000
- New mortgage = $140,000
At first glance, it may appear that you’ve met the requirements of a 1031 exchange.
The value of your replacement property is at least the same as your relinquished property, and the mortgage on the new property is at least the same as what you had on the replacement property. Best of all, you have more than enough money from your 1031 proceeds to make a down payment on the replacement property, even using a conservative LTV of 70%.
Unfortunately, by increasing the LTV from 50% on the relinquished property to 70% on the replacement property, you’ve also created mortgage boot to the tune of $40,000 by over refinancing:
- 1031 proceeds held by QI = $100,000
- Down payment on new mortgage with 70% LTV = $60,000
- Boot cash created by a bigger mortgage = $40,000 returned and subject to capital gains tax
If you’re in the 20% capital gains tax bracket, the mistake you made by over refinancing has created an $8,000 tax liability.
There are a few things you could have done to avoid creating boot from the replacement property mortgage:
1. Pay $240,000 for the replacement property (20% more than the market value)
Obviously this isn’t a good idea. But believe it or not, some investors rationalize overpaying to avoid capital gains tax because property appreciation in the market is strong, and they expect that trend to continue.
The fact is that real estate markets historically cycle up and down. Investors who overpay this much for property run the very real risk of the asset losing market value when the market turns and the investment financial underperforming due to the high acquisition cost.
2. Buy two replacement properties instead of one
It goes without saying that investing wisely by buying more than one property is a much better idea than overpaying for a single asset that will likely underperform. In fact, by looking on the Roofstock Investment Property Marketplace you can find turnkey rental property while still using a conservative leverage of 70%:
- Market value of relinquished property = $200,000
- Mortgage debt on relinquished property = $100,000
- 1031 proceeds held by QI = $100,000
Property #1
- Market value = $150,000
- Mortgage with 70% LTV = $105,000
- Down payment using part of 1031 proceeds = $45,000
Property #2
- Market value = $183,500
- Mortgage with 70% LTV = $128,450
- Down payment = $55,050 using remaining balance of $55,000 in 1031 proceeds plus $50 out of pocket
By purchasing two replacement properties instead of one, you’ve met all of the requirements of your 1031 exchange – replacement property market value is greater, mortgage debt is greater, and no cash is being returned. Plus, you’ve also grown your rental property portfolio that much faster.
Granted, in this example, you would have to add an extra $50 of personal funds. But that’s a lot better than giving $8,000 in capital gains tax to the IRS.
If you’d like more info on how Roofstock can help you with your 1031 exchange, go here.
How to Avoid Boot in a 1031 Exchange
There are a few simple rules of thumb to follow to avoid boot in a 1031 tax-deferred exchange:
- Trade up in real estate value with one or more replacement properties.
- Reinvest all of your 1031 exchange proceeds from the relinquished property into the replacement property.
- Maintain or increase the amount of debt on the replacement property.
- Personal property such as appliances should be included in the purchase price or handled in separate transactions.
- Do not create boot by over financing the mortgage on the replacement property.
- Bring cash to closing to pay for items that are not like-kind such as rent prorations, tenant deposits, or outstanding vendor invoices.
Boot Isn’t Always Bad
Receiving a little extra boot from a 1031 exchange isn’t necessarily a bad thing.
True, you’ll need to pay capital gains tax, but you’ll also have some cash available to personal use or to invest in assets that the IRS doesn’t allow in a 1031 exchange, such as precious metals or stocks.
However, to make the most from your real estate investments it’s a good idea to avoid 1031 exchange boot as much as possible:
- Boot in a 1031 exchange can be created on purpose or accidentally.
- Capital gain tax on boot can be as high as 20% depending on your income bracket.
- Factors that can create boot include cash proceeds, mortgage reduction, non-like-kind property, and non-transactions costs such as tenant deposits.
- A good way to avoid mortgage boot is by purchasing more than one replacement property.
