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Tax Tips: How to Avoid “Boot” During Your 1031 Exchange

Engaging in a 1031 exchange is an excellent way to defer your capital gains taxes. However, there are some situations where you could end up owing taxes on at least a portion of your sales proceeds. 

The taxable portion of a 1031 exchange is commonly referred to as boot.” This is an old English term that means in addition to.” Usually, boot is in the form of cash taken from the sale, an installment note, debt relief or personal property received or any non-like-kind property received.  Any boot received is taxable to the extent of the amount of capital gains realized during the transaction.

Some investors purposely pull cash out of an exchange, knowing they will owe taxes. We often encourage our clients to take “a little of the table” to enjoy a portion of their gains – and paying some taxes is not a bad consequence. With that exception, people engage in a 1031 exchange with the intent of deferring all capital gains taxes and it is desirable to avoid boot whenever possible. 

Types of Boot and Ways to Avoid Them 

There are several ways an investor can create boot during a 1031 exchange:

Cash Boot 

Purchasing a replacement property worth less than the property you sold is one of the most common ways to create cash boot. For example, if you sold a $500,000 property and replaced it with a $400,000 property, the $100,000 that was not reinvested is considered boot. 

Having a promissory note included in the exchange would also create boot. If you required the seller to pay for repairs during the transaction, the value of the repairs is taxable boot. The same applies if you earned interest on the sale proceeds of your relinquished property while the money was being held for your new purchase. 

Debt Relief

If the debt you owe on your replacement property is less than what you owed on your relinquished property, the difference is taxable boot. For example, if you initially had a $200,000 mortgage and you take out a $150,000 mortgage on the new property, the $50,000 difference is taxable. This is true even if you use 100% of your sale proceeds to purchase your replacement property. 

Non-Qualified Expenses

Using a portion of your sales proceeds to pay non-qualified expenses will also create boot. Investors sometimes inadvertently create boot by using sales proceeds to pay for services like utility escrow charges or rent prorations. To avoid boot in these scenarios, make sure to pay for all non-1031 qualifying expenses with cash out-of-pocket.   

Optimize Your 1031 Exchange 

We strongly suggest that investors who are planning to complete a 1031 exchange work closely with an experienced real estate tax advisor who can review details of the exchange and advise on whether the transaction will create boot.

DSTs and Boot

Since DSTs can be divisible to the penny, they can prove to be a useful means of avoiding boot. Through mixing and matching DSTs having different loan ratios with other selected replacement assets, we are often able to minimize or even eliminate remaining boot in a transaction.  

The professionals at FGG1031 / First Guardian Group have been advising clients on 1031 exchange transactions for more than 18 years. We would be pleased to review your exchange and assist with proposing options that may reduce your tax obligations. 

Please contact us to schedule a personal appointment.

Help Save 1031 Exchanges
Write to your Member of Congress and Senators urging them to oppose restricting Section 1031 like-kind exchanges. As part of the American Families Plan, the Biden Administration has proposed eliminating the application of Section 1031 for gains greater than $500,000. Like-kind exchanges have been part of the U.S. tax code since 1921 and are one of the tax code’s most powerful economic tools. It is critical that we all vigorously and visibly oppose this proposal. Make your voice heard with a pre-filled letter, which you can customize to add personal anecdotes or powerful client stories to highlight the positive impact of Section 1031 like-kind exchanges. Take action today by clicking HERE.

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Paul Getty

Paul Getty is a licensed real estate broker in the state of California and Texas and has been directly involved in commercial transactions totaling over $3 billion on assets throughout the United States. His experience spans all major asset classes including retail, office, multifamily, and student, and senior housing. Paul’s transaction experience includes buy and sell side representation, sourcing and structuring of debt and equity, workouts, and asset and property management. He has worked closely with nationally prominent real estate brokerage and investment organizations including Marcus Millichap, CB Richard Ellis, JP Morgan, and Morgan Stanley among others on the firm’s numerous transactions. Paul also maintains a broad network of active buyers and sellers of commercial real estate including lenders, institutions, family office managers, and high net worth individuals. Prior to founding First Guardian Group/FGG1031, Paul was a founder and CEO of Venture Navigation, a boutique investment banking firm specializing in structuring equity investments made by institutions and high net worth individuals. He possesses over 35 years of comprehensive worldwide business management experience in environments ranging from early phase start-ups to multi-billion-dollar corporations. His track record includes participation in IPOs and successful M&A activity that has resulted in investor returns of over $700M. Paul holds an MBA in Finance from the University of Michigan, graduating with honors, and a Bachelor’s Degree in Chemistry from Wayne State University. Paul Getty holds Series 22, 62, and 63 securities licenses and is a registered financial representative with LightPath Capital Inc, member FINRA /SIPC. Paul is a noted speaker, author, and actively lectures on investments, sales, and management related topics. He is author of The 12 Magic Slides, Regulation A+: How the JOBS Act Creates Opportunities for Entrepreneurs and Investors, and Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST), available on Amazon and other retail outlets.

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