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:
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.
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.
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.