Boot is an old English term that refers to something that is given in addition to something else. As an example, when people commonly traded livestock or horses many years ago, it might be the case that one horse was worth more than another and that the exchange would need to be supplemented with something else of value to even up the trade (currency, sugar, tobacco, etc.).
Items of additional value to balance a trade came to be called “Boot.” In a 1031 Exchange, boot is an industry term for additional money or value received in the exchange and can result in a tax liability to the seller of an investment property.
Three Rules for a Full 1031 Exchange
Let’s recap the three rules that must be followed to fully defer all capital gains and depreciation recapture taxes in a 1031 Exchange:
- Purchase qualifying “like-kind” Replacement Properties with a total value equal to or greater than the sales price less selling expenses of the Relinquished Property
- Reinvest all the net proceeds from the sale of the Relinquished Property in the purchase of the Replacement Properties; and
- Make sure the debt on the Replacement Property is equal to or greater than the debt on the Relinquished Property by either a) assuming existing debt b) obtaining new debt, or c) adding cash from outside of the exchange to the transactions which will reduce the debt requirement dollar-for-dollar.
For example, if your investment property sold for $1,000,000 (after expenses) and you then paid off an existing $400,000 loan, for a full tax deferral, you would need to do the following:
- Purchase qualifying Replacement Properties valued at $1,000,000 or greater
- Reinvest your net proceeds of $600,000 after paying off the $400,000 loan
- Either obtain or assume a new loan of at least $400,000 or bring in added funds from outside the exchange e.g., sale of stock, funds from your bank account, etc. to reduce the debt requirement.
Consequences of Boot in a 1031 Exchange
Failure to fully meet all three rules will not disqualify the exchange, but any shortfall will be considered “boot” and generally subject to tax liabilities which in some states can total up to 40%.
Boot can arise from the following:
- Cash proceeds an Exchanger takes from escrow/settlement before the remaining proceeds are sent to the 1031 Qualified Intermediary
- Not using all the cash proceeds remaining after the 1031 Exchange has been completed
- Failure to identify sufficient qualified Replacement Properties in your allowed 45-day 1031 Exchange ID period that you can subsequently purchase
- Investing 1031 Exchange proceeds in non-qualified property such as personal property, stocks, bonds, notes, or partnership interests
- Purchasing Replacement Properties of lesser total value than the Relinquished Property
- Failure to fully offset the debt requirement on the Replacement Property
How to Avoid Boot in a 1031 Exchange
The most common problem that investors encounter which creates boot is the inability to exactly meet all the three exchange rules described earlier. As an example, a desired Replacement Property may be of lesser value than the Relinquished Property, the new loan may be less than what is needed, or the investor may wish to take some funds out of the exchange.
DST structured properties can often provide a solution to reduce or even eliminate boot.
- Minimum investments for DSTs can be as low as $50,000 (sometimes even less) which may allow investors to fill a gap between the required value of the properties in an exchange
- DST properties can be acquired in increments down to the penny if needed to precisely match investor needs
- Many DSTs already have debt in place that can be used to meet outstanding debt replacement requirements
Want a Completely Tax-free 1031 Exchange?
If your goal is a 100% tax-free 1031 exchange, be sure to first contact our team at First Guardian Group/FGG1031 for a no-cost no-obligation consultation and analysis of your options. Our extended team includes experienced tax advisors and 1031 qualified intermediaries (QI) who may help you carefully structure your exchange to avoid surprises.
You can contact us at (408) 392-8822 or via email at info@FGG1031.com.