1031 Exchange Boot: Identifying Causes, Understanding Impact, and Strategies for Prevention
In a 1031 Exchange, “boot” refers to any cash or non-like-kind property received by the taxpayer during the exchange process. Investors that want to avoid taxable income from their exchange should understand the various factors that can result in unplanned boot.
In a 1031 Exchange, “boot” refers to any cash or non-like-kind property received by the taxpayer during the exchange process.
Boot introduces a taxable gain into the transaction, potentially jeopardizing some of the tax-deferral benefits intended by the exchange as the taxpayer must recognize gain up to the amount of boot received.
The gain is calculated by comparing the adjusted basis of the relinquished property with the fair market value of the replacement property received. At the federal level, boot is taxed by the IRS as ordinary income (IRS form 8824), meaning the specific tax rate will be determined by the investor’s tax bracket. At the state level, any taxes will depend on that state’s individual tax laws.
While boot may create complications for some exchangers, others may choose to intentionally take constructive receipt of a portion of their sales proceeds to help address liquidity needs. The receipt of boot doesn’t disqualify the investor from executing the exchange. Instead, the exchanger will have a partially tax deferred exchange rather than a fully tax deferred exchange.
Investors that want to avoid taxable income from their exchange should understand the various factors that can result in unplanned boot.
Cause of 1031 Exchange Boot #1:
Cash Boot
Cash boot can occur when an exchanger fails to invest all profits from their property sale into a like-kind asset or fails to transfer any gains to the Qualified Intermediary facilitating their exchange. Additionally, cash boot can accumulate from the interest earned on sale proceeds while acquiring a replacement property or if sales proceeds are used to service non-transaction costs at closing. Some examples of what these costs may include are outlined below.
Permissable Expenses:
Owner’s title insurance premiums
Escrow agent, settlement agent or closing attorney fees
Real estate broker’s commissions
Finder fees or referral fees
Qualified Intermediary fees
Documentary transfer taxes
Recording or filing fees
Attorney fees and costs related to the disposition or acquisition
Tax advisor fees related to the disposition or acquisition
Non-Permissable Expenses:
Prorated Property taxes
Prorated rents
Insurance premium payments
Security deposits
Payoff of credit card balances
Repairs and/or maintenance costs
Personal Expenses
Financing or lender related costs (prorated interest expense, loan fees, loan points, appraisal fees, mortgage insurance premiums, lender’s title insurance policy premiums, and loan processing fees)
Investors should consider bringing cash to the closing of the sale of their relinquished property to pay for non-transaction costs.
Typically, any cash proceeds remaining after the exchange ends will be in the form of “net cash received” at the closing of either the relinquished property or the replacement property. Under U.S. Generally Accepted Accounting Principles (GAAP), cash boot is allowed to be part of a nonmonetary exchange, but will be considered taxable income.
Cause of 1031 Exchange Boot #2:
Mortgage Boot
Referred to as either a debt reduction boot or a mortgage boot, this type of boot is the result of an uneven 1031 Exchange that ultimately leads to a mortgage or debt reduction. This can occur when an investor acquires a replacement property with a smaller mortgage than their relinquished property–even if all sale proceeds are used to purchase the property.
Despite following all other exchange-related rules, the decrease of debt liability upon acquiring a replacement property constitutes mortgage boot, which is subject to taxation.
Cause of 1031 Exchange Boot #3:
Non-Like-Kind Property
Receipt of assets such as stocks, bonds, or personal-use property instead of like-kind real estate can qualify as boot. Because the inclusion of personal or non-like-kind property can often happen accidentally, it’s important to clearly state which items are included and excluded from the sale. Items that aren’t included in the property sale can still be purchased by investors through a separate sale agreement. Just remember to avoid using the sale proceeds of the relinquished property for the purchase!
Cause of 1031 Exchange Boot #4:
Handling Prorated Rents and Security Deposits
Occasionally, the purchase of rental property will include prorations for expenses like prepaid rent and/or security deposits. In this situation, the addition of a prorations clause to the purchase and sale agreement can help determine how any prorations will be handled. To avoid confusion or unintended tax consequences, the prorations clause should clearly define the prorations as part of the exchange proceeds and state how these amounts are adjusted between the buyer and seller at closing.
Example:
An investor is purchasing a rental property for $500,000. As part of the sale, there are prorations for expenses like prepaid rent and security deposits:
Prepaid Rent: The seller has already collected $5,000 in rent payments from tenants that cover a period after the sale closes.
Security Deposit: The seller also holds a security deposit from tenants amounting to $1,000.
Incorrect Approach: A prorations clause is NOT added to the purchase and sale contract to determine how these amounts are adjusted between the buyer and seller at closing.
Results: The seller credits $6,000 directly to the buyer at closing to adjust the purchase price.
Tax Consequences: Because the funds weren’t deposited into the exchange account, they are viewed as additional cash received outside of the exchange, potentially triggering tax liability on the amount.
Correct Approach: A prorations clause IS added to the purchase and sale contract which clearly states that prorated rents and security deposits are part of the exchange proceeds and must be transferred to the qualified intermediary.
Results: Before the closing of the sale, the $6,000 in prorated rents and security deposits is placed into an escrow account managed by the qualified intermediary (QI).
Tax Consequences: The $6,000 in prorated rents and security deposits is treated as part of the exchange proceeds.
Documents to Review to Help Avoid 1031 Exchange Boot
While some potential causes of boot are easy to spot, it is best to ensure nothing is overlooked. Careful review of transactional documents is crucial to avoid inadvertent boot. It is advisable to consult with qualified tax advisors and legal professionals to structure transactions properly and minimize boot exposure. Their expertise can ensure compliance with IRS guidelines and optimize the benefits of a 1031 Exchange.
Before finalizing sales or purchase, Legacy recommends that an exchanger have their lawyer and tax preparer review key documents, including:
Sale agreement (relinquished property):
Review the sales contract for the relinquished property to understand the terms of the exchange.
Pay close attention to the sales price and any adjustments or credits.
Purchase agreement (replacement property):
Review the purchase contract for the replacement property to ensure it meets the requirements for a like-kind exchange.
Pay close attention to the purchase price and any adjustments or credits.
Closing statements:
Obtain and review the closing statements for both the relinquished and replacement properties.
Pay close attention to the allocation of expenses, credits, and adjustments related to the exchange.
Financial statements and tax returns:
Review the taxpayer’s financial statements and recent tax returns to understand the taxpayer’s financial position.
Pay close attention to any potential impacts of boot on tax liabilities.
Cash flow analysis:
Perform a cash flow analysis to assess any potential cash or non-like-kind property that might be received.
Pay close attention to whether any cash or non-like-kind property that could be considered boot.
Mortgage and debt details:
Review the details of any mortgages or debts assumed or paid off in the exchange.
Pay close attention to properly accounting for mortgages or debts to ensure they do not result in boot.
Three Rules for Avoiding Boot in a 1031 Exchange
To avoid boot and maintain full tax deferral benefits under a 1031 exchange, it is recommended that the Exchanger follow these three rules:
Purchase replacement property of equal or greater value than the relinquished property.
Reinvest all net proceeds from the sale of the relinquished property into the replacement property.
Ensure the debt on the replacement property is equal to or greater than the debt on the relinquished property.*
*Exception: a taxpayer can offset a reduction in debt by adding new cash to the replacement property closing in an amount that is the same or exceeds the reduction in debt.
Using DSTs to Mitigate 1031 Exchange Boot
Delaware Statutory Trusts (DSTs) offer a potential solution for avoiding boot and unnecessary tax liability. By reinvesting excess cash or debt boot into a DST, investors can maintain the tax deferral benefits of their exchange and gain the potential for passive income.
Executing a successful 1031 Exchange requires careful planning and adherence to IRS rules. By understanding boot and implementing strategies to avoid it, taxpayers can maximize tax deferral benefits and achieve their investment goals effectively.
At Legacy, we work with you to build an 1031 Exchange strategy tailored to your unique goals and specific needs. Give our knowledgeable team a call to learn more about the potential benefits of utilizing the Delaware Statutory Trust to mitigate boot.
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Because investor situations and objectives vary this information is not intended to indicate suitability or a recommendation for any individual investor.
This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.
There are material risks associated with investing in private placements, Delaware Statutory Trusts (“DSTs”) and real estate securities including the potential loss of the entire investment principal, illiquidity, tenant vacancies impacting income and revenue, general and real estate market conditions, lack of operating history, interest rate risks, competition, including the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and investors should read the PPM carefully before investing paying special attention to the risk section.
Risks associated with 1031 exchange - A 1031 exchange has an identification period of 45 days from the sale of the relinquished property to identify a potential replacement property or properties depending on the value of the previous property. To defer all capital gains tax, you must reinvest the entire net proceeds from the sale of the relinquished property into the replacement property and acquire debt on the new property that is equal to or greater than the debt on the property that was just sold and relinquished
Registered Representative and securities offered through Concorde Investment Services, Inc. (CIS), member FINRA/SIPC. Legacy Investments & Real Estate, LLC. is independent of CIS.
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