What is 1031 Exchange Boot?
While section 1031 exchange
of the IRS code offers an excellent opportunity for Real Estate investors by means of deferred tax exchange, the investor also needs to be very careful about getting into a 1031 exchange boot. If they do, they might still end up with a tax bill that they were trying to defer.
Currently under the IRS 1031 exchange rules, only "like kind" property held for business or investment purposes qualifies for a 1031 exchange. However, there are a number of things that if included as a part of the exchange, can trigger a capital gain tax bill on the portion of the exchange that they represent. These examples are called a 1031 exchange boot. It is advised to ask your Qualified Intermediary about the possibility of triggering a boot when executing a 1031 exchange.
A 1031 exchange boot can include any item in the trade that is not of the "like kind" as defined under section 1031 of the IRS tax code. Quite often people mistakenly get these boots included in their 1031 exchange, and they unfortunately will end up with a capital gain tax bill.
The two most common types of boots that a real estate investor come across are a Mortgage boot and Cash boot. There are also many other types of boots like personal residence boot, and personal property boot, etc.
Let's first understand the Mortgage Boot. A mortgage boot on your 1031 exchange takes place when the property you buy has a mortgage debt of lesser value than the mortgage debt on the property you happen to sell. It is strongly advised that the real estate property you buy should have a mortgage debt equal to, or greater than the property you are selling. In the rare case that the real estate property you buy has a lesser mortgage debt amount than the property sold, the difference in the mortgage value will be taxable to you, unfortunately.
To Avoid a 1031 Exchange Mortgage Boot two things can be done, Number 1: In the situation that the seller of the property refinanced the property and you happen to assume the new higher debt. You are allowed to finance it through a new loan or a "land sale" contract. Number 2: Simply add cash to the deal and the cash added into the deal offsets the debt relief on the property sold by you. It should be the responsibility of your Qualified Intermediary to help you on this.
Now lets talk about a Cash Boot. By definition any cash or other cash equivalent value received ex. (promissory note) in a 1031 exchange is also not included in the "like-kind" property and is considered as a cash boot. On any such income from capital gain taxes are applicable or if the cash amount is a composite amount of principal and interest, the capital gain taxes are always charged on the principal amount. If this cash happens to be held for a longer period and you earn any interest payment from that, those interest payments will also be taxable as regular income.
Keep in mind, if the seller is paying cash for any repair charges that are required by the buyer then the amount paid by the seller towards the repair charges are considered as a cash boot and then it would also be taxable. Ask your 1031 exchange intermediary (QI) on advice on how to avoid this type of 1031 exchange, cash boot.
A less common type of Boot is a Personal Property Boot. This is often an investment property that would include appliances such as stoves, washers & dryers, refrigerators etc and if these items are included in the sale you can end up paying capital gain taxes for these appliances. All appliances are not considered "like kind" property.
This situation can very easily be avoided by simply stating in the deed that all the appliances are not "part of the sale". You have the ability to create a separate sale agreement for the appliances for the amount of one dollar. By doing this, you can hide the price of the personal property or Appliances in the sales agreement. Your (QI) should always make sure that these appliances are not included as a part of the "real estate" sale. If it did it would also interfere with proper execution of a 1031 exchange.
Another less common type of Boot is a Personal Residence Boot. This takes place when Investment property and personal residence property are not considered "like kind" property. So if you are buying a 4 family as part of a 1031 exchange, and then use one of the units as your personal residence, then 1/4 of the property would be considered as a 1031 exchange boot and you will have to pay taxes on that.
This can be simply avoided by waiting for the 1031 exchange to be completed and till the time you have paid the taxes for that year. After that you can move in to your new personal residence and the personal residence boot is avoided. Again ask your (QI) about avoiding the possibility of this Boot.
In the case when you have a Dealer Property and Rental Property. Dealer property and rental property are not "like kind" property under any section of the 1031 IRS tax code. A dealer property is considered as an inventory where in the case of a rental property it is considered an investment. If you are doing a 1031 exchange for just a dealer property, it could be a problem, the problem comes when you are disposing off a "dealer property" under section 1031 of the IRS tax code. Dealer property being legally termed as simply inventory is not fit for a 1031 exchange. Although this type of exchange does take place, the IRS can always detect these under an audit, and in that case you will be forced to pay for taxes and penalties on the sale of the dealer property.
Disclaimer: 1031 exchange made simple does not guarantee the performance of the QI's in our referral network and we can not be held liable for any misrepresentations or mistakes in regards to a 1031 exchange by one of the QI's that we refer to you. 1031 Exchange made simple does not provide tax advice nor can we make representations regarding the tax consequences of an exchange transaction. 1031 Exchange made simple is a 1031 QI Referral Network. 1031 made simple is not responsible (in any way) for the performance, creditability, and financial condition of any QI in our network. In this new economic environment it is imperative that all potential 1031 exchange customers do their own due diligence and research on any QI that they may use, on a 1031 exchange. Please verify and check the validity of the Bonding and Insurance of your QI. It may be wise to have your 1031 exchange accounts set up as separate, individual customer accounts. Our web site is to be used as a information based web site only. All parties doing a 1031 exchange must consult their tax advisors or attorney for this information.