A 1031 Exchange is a real estate transaction that allows real estate investors to defer capital gains taxes on the profitable sale of an investment property. For many, this is a popular – and effective – strategy through which to grow and diversify a real estate portfolio over time. But, to take full advantage of this program, the IRS has established a set of rules that commercial real estate investors must abide by.
In this article, the basic rules of a 1031 Exchange are described, with a special focus on something called “boot.” We will describe what boot is, how to avoid it, and what happens if it is realized. By the end, readers will understand exactly what boot is and how to manage its appearance in a 1031 Exchange.
At First National Realty Partners, we frequently work with investors looking to place 1031 Exchange proceeds. To learn more about our current commercial real estate investment opportunities, click here.
What Are the Rules of a 1031 Exchange?
The basic premise of a 1031 Exchange is this. If a real estate investor sells a property (the “relinquished property”) for more than its calculated tax basis, there is a “gain” and it is taxable. The exact amount of taxes owed is dependent upon the taxpayer’s income, tax bracket, and the amount of time the property was held before it was sold. However, these taxes can be deferred if the taxpayer uses the sale proceeds to purchase another property (the “replacement property”) that is considered to be “like kind.”
To qualify for full tax deferral, investors must follow a series of rules that are defined in section 1031 of the internal revenue code. They include:
- Property Use: 1031 Exchange properties must be “held for productive use in a trade or business or for investment.” In other words, most personal properties such as primary homes and vacation homes likely would not qualify.
- Time: Real estate investors must identify their replacement property within 45 days of sale and must complete their purchase within 180 days of sale.
- Boot: To qualify for full tax deferral, investors cannot receive “boot.” Any boot received is taxable.
This last rule regarding boot is the focus of this article.
What is Boot?
Simply, boot is the fair market value of “other property” received by the taxpayer in a 1031 exchange. Generally, boot falls into three categories.
Types of Boot
Cash Boot
Cash boot is exactly what it sounds like. It is cash received in the transaction.
Cash Boot Example
For example, suppose that a real estate investor sold a property and used the proceeds to put a $100,000 deposit on a replacement property. But, in the final settlement, they receive $105,000 back from the qualified intermediary managing the transaction. This $5,000 difference would be considered “cash boot” and it is taxable.
Mortgage Boot
Mortgage boot – sometimes called debt reduction boot – is slightly more complex. It occurs when the debt owed on the replacement property is less than the debt owed on the relinquished property at the time it was sold.
Mortgage Boot Example
For example, suppose a real estate investor sold a property for $1,000,000 and it had a loan balance of $700,000 at the time of sale. These proceeds are used to purchase a new property fpr $1,000,000, but the loan is only $500,000. The difference between the original loan balance ($700,000) and the new mortgage balance ($500,000) is considered to be mortgage boot and it is taxable.
Personal Property Boot
Personal property refers to anything received in the exchange that is not real property.
Personal Property Boot Example
For example, suppose that a commercial real estate investor purchased a manufacturing facility as a replacement property in a 1031 Exchange. As part of the purchase, they get a large amount of inventory, machinery, and other equipment. These “extras” do not qualify as real property in the exchange. Instead, it is taxable boot.
How to Calculate Boot
The process used to calculate potential boot can be complicated, but it has a material impact on the potential taxes paid in the transaction.
In general, the calculation looks at the transaction in two parts. On the sale side, it takes into account the sales price, adjusted tax basis, the cost of commissions, and any liabilities owed. On the purchase side, it looks at the price paid less any commissions, transaction costs, and mortgages.
If there is a difference between the cash received from the sale and the cash invested in the new property, it could be classified as boot.
As a general best practice, 1031 Exchange investors should work with a third party known as a qualified intermediary to ensure that all of the rules for the transaction are followed. They will assist in the boot calculation and advise their client(s) about whether or not it exists and how to avoid it.
How Boot is Taxed
Like the boot calculation, determining how it is taxed can also be complex. In addition to a qualified intermediary, investors should work with a CPA who has experience with 1031 Exchanges. They will provide detailed advice on the boot tax calculation.
That said, boot is listed on line 15 of form 8824 Like Kind Exchanges and it is taxed as ordinary income. As such, the specific tax rate depends on an investor’s individual tax bracket. For example, suppose an investor realized $100,000 in excess cash boot and they are in the highest income tax bracket of 37%. This means that there is a potential $37,000 tax liability associated with receiving this boot. However, it isn’t this simple because this liability is lumped in with all other sources of income and expenses to get to a final tax bill. Again, this can be incredibly complex and it is always a good idea to work with a CPA to assist with the preparation of a tax return.
How To Avoid Boot
The entire point of a 1031 exchange is to defer taxes so boot is usually an undesirable outcome. To avoid it, investors should consider the following rules of thumb:
- All net sale proceeds should be transferred to the the replacement property
- The value of the replacement property should be the same or greater than the relinquished property.
- There should be no excess cash left in the transaction
- Pay 1031 exchange expenses – like brokers fees and commissions – from sales proceeds.
Again, it is important to work with a qualified intermediary to minimize the chance of receiving boot. In doing so, the transaction can remain tax-free and in line with its stated purpose.
Summary & Conclusions
A 1031 Exchange is a type of real estate transaction that allows investors to defer taxes on the profitable sale of an investment property as long as the proceeds are invested into another property that is considered to be “like kind.”
To receive full tax deferral, investors must comply with a series of rules, one of which is that they cannot receive any boot in the transaction. Boot is a word used to refer to the fair market value of “other property” received in a 1031 Exchange and there are three kinds: cash, mortgage, and personal property.
If boot is received in the transaction, there are tax consequences. In most cases, it is taxed as ordinary income, but the exact tax rate varies based on each individual’s tax bracket.
The point of a 1031 Exchange is to defer taxes so it is a best practice to avoid the receipt of boot in the first place. To do this, there are several strategies including transferring all sale proceeds to the new property and paying 1031 exchange expenses like commissions and fees from exchange funds.
1031 Exchanges are complex transactions and it is always a best practice to work with a qualified intermediary, a CPA, and/or a real estate attorney who is knowledgeable in this space.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
