How Is Boot Taxed in a 1031 Exchange?

**The information on this web page is provided for informational purposes only and should not be considered as legal, tax, financial or investment advice. Since each individual’s situation is unique, a qualified professional should be consulted before making financial decisions.**

Found nowhere in the Internal Revenue Code or Regulations, yet the term boot is central to examining these exchanges. Here you’ll learn what boot is (with examples for each type), how it’s taxed, and how to avoid unwanted boot.

To plan well and minimize boot’s downsides, you or your advisor must fully understand all that boot entails in this complex process. As usual with taxation, after-the-fact corrections seldom receive favorable IRS outcomes.

This article will help you learn how to carefully consider boot’s role in your exchange’s success and get it right the first time.

 

What Is a Boot in a 1031 Like-Kind Exchange?

No secret, this gets complicated really fast so first some backdrop. The whole point of a Section 1031 exchange is for you and the other party to defer taxes with a like-kind property exchange. If yours is an unlikely direct swap–with each of you owning property that the other wants–possibly there’s no boot.

Swaps frequently are mortgage free and include no cash as part of the exchange. But finding such matches that pass IRS muster at the right time is rare. Or you may want to do a partial 1031 exchange by exchanging only a certain amount of your property’s value and taking the rest out as cash, which creates boot.

More likely, yours will be a non-simultaneous delayed exchange known as a Starker.

  1. First, your mandatory qualified intermediary (also called QIs, 1031 exchange accommodators, facilitators, or simply 1031 exchange companies) receives purchase proceeds from the buyer of your relinquished investment [1].
  2. Then within 45 days you’re required to identify a 1031 exchange replacement property(ies). Typically, you’re allowed no more than choices from which to pick one for acquisition.
  3. Finally, within 180 days of initially receiving relinquished property proceeds, you must close on the desired acquisition property.

Caution: Be sure the QI holds all your relinquished property’s sale proceeds (exchange funds) until closing on the replacement property. Receipt (even constructively) before then–or any other major violation–will convert the exchange into a taxable sale regardless of what may subsequently occur.

While Starker exchanges are all about utilizing tax-free, like-kind property, cash and cash equivalents (other property) considerations are often unavoidable. So here we go: cash and other property are not considered like-kind.

Boot is anything of value constructively received that’s not considered like-kind property. Boot is an old English word meaning something given in addition. In this case, it’s in addition to like-kind property.

Boot for §1031 purposes is cash or other property that you receive in a 1031 exchange, additionally to your replacement property, to get compensated for the difference between the fair market value of your relinquished property that costs more and your replacement property that costs less.

Money includes all cash equivalents, debt relief for your mortgage of other liabilities assumed by the other exchange party.

Other property takes various forms such as personal property, property used for personal use, rent prorations, tenant security deposits, a business, etc. Included are any service costs or prorations not actually closing expenses.

Devoting your or an advisor’s time pre-closing to remove these misclassified costs could payoff. Details are coming on how that might reduce boot. It’s another example of the need to lay the groundwork pre-closing.

Next are more details on cash boot, mortgage (debt) boot and personal property boot, as they are often categorized.

 

[1] Learn about everything a Qualified Intermediary does for you from our guide All About 1031 Exchange Accommodators (aka Facilitators or Qualified Intermediaries).

Note: it’s easier to avoid boot when exchanging a property into real estate investment trust shares. To learn more about this type of exchange, read our articles:

 

3 Types of Boot in a 1031 Tax-Deferred Exchange

The two most common forms are cash boot and mortgage (debt) boot. Less common is an other than real estate category, often called personal property boot. Yet this last category may have significant tax savings potential for you in a well-executed exchange.

 

#1 Cash Boot

After exchange closings, cash boot is defined as net cash or equivalents you hold over (constructively receive) or the fair market value of other property you retain on relinquished and replacement properties. Put another way, anything non like-kind (cash, equivalents and other property) that you possess after closing is boot.

Net cash received often results if you trade down in an exchange. Trading down is when replacements cost less than relinquished properties sold for. Another instance is when a portion of your cash contribution is returned to you unspent. The QI will return it to you as cash boot.

 

#2 Mortgage Boot

If you trade down (replacement worth less than the relinquished property) in the exchange, debt reduction boot may occur at the time of sale. This happens when outstanding replacement property debt is less than your relinquished property’s debt. Then capital gains tax is imposed on the difference debt amounts.

Too easy, it gets stickier when boot netting rules get involved.

  1. Cash boot paid on either relinquished and replacement property closing offset mortgage boot received, but not between the two closings.
  2. Mortgage boot paid on the replacement side offsets mortgage boot received relinquished properties side.
  3. Mortgage boot paid can’t be netted cash boot received.

An example is coming up later.

 

#3 Personal Property Boot

Generally, with enactment of the Tax Cuts and Jobs Act (TCJA), personal property no longer qualifies as §1031 like-kind property after 2017. Section 1245 Personal Property was no longer included with §1250 real estate property as like kind.

Personal property included either in a purchase or sale is now personal property boot, with some exceptions. Taxable properties include ones held for personal use and §179 depreciable property such as inventory, appliances, tools, and other equipment.

Understandably, the Act created uncertainty among investors and their consultants alike. Now e.g. could including lobby furniture (personal property) in a hotel exchange risk its collapse?

The ensuing June 11, 2020 proposed regulations provided for a qualified personal property inclusion clause, which addressed this question pending final rules publication. Basically it called for personal property incidental to replacement real property to be disregarded in determining §1031 eligibility. IRS’ Supplementary Information reads:

Personal property is incidental to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property, and the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property.

Note: If from the January 1, 2018 effective date, you fully and consistently followed the new guidelines, those rules would apply retroactively to that date.

The good news is Final Rules published and effective on December 2, 2020 largely retained proposed regulations provisions.

Generally qualifying as real property for exchange purposes are:

  • incidental personal property not exceeding 15% of the aggregate fair market value of the replacement real property, [2]
  • real property specifically listed as qualifying such as land and most anything permanently built on or attached to land,
  • property categorized as real property under applicable State or local law,[3] and
  • certain intangible property e.g. leaseholds or easements.

[2] Per final regulations language the 15% limitation is calculated by comparing the value of all incidental properties to the value of all replacement real properties acquired in the same exchange.

Further this limitation shouldn’t be considered a bright-line test. All applicable facts and circumstances are to be considered in determining whether the exchange is §1031 qualified.

[3] Even classified as personal property under state or local law, it can still qualify as real property if specifically listed in Regs. Sec. 1.1031(a)-3(a)(2)(ii) as includable.

Whether a property qualifies as like kind remains unchanged. If on the transfer date property is classified as real property under State or local law, it remains so.

Any consideration of whether the particular property contributes to the production of income unrelated to the use or occupancy of space was eliminated. Referred to as the purpose or use test, it was removed from the definition of real property. The IRS acted in response to practitioner complaints that this test was overly burdensome.

Finally, in §1.1031(a)-3(a)(7), the final regulations retain the language of the proposed regulations. It’s made clear these regulations apply only to §1031 provisions. No inferences can be applied to other code sections. Personal property depreciation rules e.g. would remain unchanged.

Investors should consider seeking advisory help interpreting the significance of these new rules.

 

Examples of a Like-Kind Exchange with a Boot

Sometimes boot is unavoidable, other times a choice, and still other times it’s a mistake, a planning failure on tax avoidance.

Disclaimer: these examples don’t reference closing costs, which inevitably reduce both net sales price and net equity.

 

Cash Boot

1) Sometimes boot is a choice. For $500,000 you exchange mortgage-free property with an adjusted basis of $300,000 for a $600,000 replacement property.

  • Rather than putting the full $500,000 into your replacement, you decide to take $50,000 out of equity for a once in lifetime opportunity.
  • Remaining equity of $450,000 goes toward the replacement property with the balance finance.
  • This $50,000 is taxable boot as non like-kind value (cash) received.

 

2) Sometimes trading down happens when suitable replacement properties are limited. You exchanged your debt-free relinquished property for $800,000.

  • With an adjusted basis of $500,000 you have a $300,000 capital gain.
  • Your replacement has a $700,000 basis, also debt free.
  • Having exchanged your $800,000 property for a $700,000 asset, cash boot of $100,000 is realized.
  • Still $200,000 can be deferred, i.e. the $300,000 relinquished property gain minus $100,000 taxable boot.

 

3) Still other times boot is avoidable. Your property with a $400,000 basis goes for $500,000 but the property you want is priced at only $450,000,

  • Going forward now means trading down with $50,000 in taxable boot and a $50,000 rather than $100,000 capital gains deferral.
  • Your broker recommends also buying the adjoining vacant lot for $75,000. Now with $525,000 in replacements exchanging for your $500,000 relinquished property, there’s no boot.
  • The full $100,000 capital gains deferral is retained.

 

 

Mortgage Boot

Reducing debt effectively increases income, a taxable event. Boot occurs when your replacement property debt is lower than that on the relinquished property. Debt reduction can be offset with purchase cash. 1031 exchanges defer taxes on such income only if it is reinvested in a replacement property.

1) Boot happens when replacement debt is less than relinquished property debt.

  • Your relinquished property with a $200,000 basis goes for $400,000 while carrying a $100,000 mortgage balance.
  • Now with equity of $300,000 you acquire another property for $500,000 with no mortgage outstanding.
  • Ended here, you’ve realized a taxable $100,000 in mortgage boot.

 

You may think you just utilizing the $300,000 in equity is enough for full tax deferral. But §1031’s intent is to defer not eliminate the capital gains tax. That’s debt relief using capital gains from the relinquished property sale. It’s a gain meant to be deferred only by §1031.

2) Escape mortgage boot with a non-exchange fund (outside) cash payment.

  • Same facts as above.
  • But instead, to avoid boot, you come up with $100,000 outside cash toward purchase of the replacement property. Effectively you’re realized $100,000 in mortgage boot and paid $50,000 in cash boot. It’s a wash, an offset that we’ll cover later.

 

Personal Property Boot

1) You’re into manufacturing and looking at a $1M furniture making plant that includes $200,000 in §1245 depreciable property (inventory, appliances, tools, and other equipment).

  • Your debt-free relinquished property goes for $1M.
  • The $200,000 in equipment is not like-kind §1250 real estate property and therefore creates taxable boot to the extent of any capital gains.

 

2) Same facts except you prepare a separate sales agreement and pay personal property costs with out-of-pocket funds.

 

How Is Boot Taxed in a 1031 Tax-Deferred Exchange?

To repeat an earlier observation: the whole point of a §1031 exchange is for you and the other party to defer taxes with a like-kind property exchange. Fully successful, you’d have nothing to report for tax purposes until these properties are sold outright.

But then there are outliers such as boot being taxable to the extent of capital gains. If as part of the exchange, you also receive other property (non like-kind) cash, mortgage, or personal property boot, gain is recognized as taxable.

Boot is reported on line 15 of Form 8824 Like-Kind Exchanges (below) and taxed at your ordinary tax rates. Ordinary income under recapture rules is reported on line 21 of Form 8824 and line 16 of Form 4797 Sales of Business Property. This includes §1245 personal property subject to depreciation recapture taxation.

Personal Property Boot

Note: Depreciation recapture on §1245 other property is taxed at your ordinary income tax rate, not the higher §1250 real estate recapture rate (around 25%) or the lower capital gains rates.

Since depreciation reduces a depreciable asset’s taxable ordinary income, gain on its disposal is tax as ordinary not favorable capital gains income.

Say a forklift costing $10,000 was depreciated at $2,000 per year. Its adjusted tax basis four years later is $2,000 ($2,000 X 4 = $8,000 from $10,000). Sold then for $3,000 a $1,000 depreciation recapture gain is realized.

One might think rather that it’s a loss ($10,000 acquisition sold at $2,000). But capital gains/losses are realized from adjusted not original cost basis. And, this is all about this gain no longer being deferred in your §1031 exchange.

Then there’s more complexity if you haven’t had enough already.

 

Reporting of Multi-Asset Exchanges

If you exchanged multiple groups of like-kind or cash/other properties, leave blank lines 12 through 18 of Form 8824. Instead, attach a statement showing how you computed the realized and recognized gain.

Enter those amounts on lines 19 through 25 of Form 8824. Also report any recognized gains on the applicable form, i.e. Schedule D, Form 4797 Sales of Business Property, or Form 6252 Installment Sale Income.

An exchange is a multi-asset exchange only if you transferred and received two or more groups of like-kind properties, cash, or other (non like-kind) properties. All properties must be grouped accordingly. Then deferred gain/loss and basis is allocated between these exchange groups.

Benefit may arise with this aggregation. It enjoys an exception to the general requirement that gain and basis be computed asset by asset. When aggregating by group, gain is only recognized in aggregate for your relinquished and replaced groups.

Then each group’s basis for the replacement property is determined separately, not for the whole property. Deferrals in total may then be greater than executing several exchanges of multiple properties.

 

Can I Avoid Boot Taxation?

Cash Boot

Boot avoidance ranges from simple proactive steps to more aggressive measures such as refinancing. Here are some generic rules of thumb.

  1. Transfer all of your net proceeds to the replacement property.
  2. Strive to receive replacement property that’s at least as valuable as that relinquished.
  3. Leave no excess cash with the QI resulting in cash boot.

 

Boot Avoidance on Transactional Service (Exchange) Expenses

These are expenses related to sales or purchases. Using exchange funds to pay service costs creates no taxable boot. They include broker’s commissions, transfer taxes, recordation costs, title insurance, attorney fees, finders fees, and condo association fees.

If you pay any of these fees with exchange funds, the exchange is unaffected. Then post-closing on relinquished property, you’re considering the common practice crediting the buyer’s purchase price. With no additional direct cost to you, why not?

For example, with your house selling for $500,000, there’s $50,000 in service expenses. As a credit, you would reduce the sales price to $450,000. But doing so may result in $50,000 boot.

Though not required by exchange rules, a solution is to pay the $50,000 out of pocket. Doing so, should you trade even up (even or up) for replacement property, you’ve avoided $50,000 in boot.

 

Escaping Boot on Non-Transactional Service (Exchange) Expenses

These are costs not related to closings but often included nonetheless, intentional and not. You and any advisors should carefully review them. They include such items as rent prorations, electricity/gas utility escrow charges, recent repair/maintenance invoices, etc.

These expenses and possibly others including loan acquisition costs and closing prorations are not generally considered closing costs. At closing, you have the right to contest any costs being paid out of exchange funds.

A contested area just mentioned are replacements’ loan acquisition costs, i.e., origination and other related fees. The IRS and lenders may say they come out of exchange funds. Taxpayers typically contend loan proceeds should be the source.

In any event, paying them out of pocket will offset constructive cash being received, à la boot. Another good reason to bring enough cash to closings whenever possible.

 

Rather Than Crediting, Transfer Income Items Directly to Buyers

Likewise for income items, discouraging settlement statement preparers from regularly giving credits to buyers may be in order. Rather, you should transfer such items as prepaid rent and security deposits directly to the buyer.

Say you hold as a seller deposits totaling $50,000. Often buyers are given credit so now your $500,000 property has a $450,000 net value. Rather with adequate funds, you’re encouraged to pay the buyer directly so the property’s value remains $500,000.

Then should you trade even up for replacement property, there’s no boot. Same for earnest money. Unless the QI is instructed to take earnest monies out of exchange proceeds prior to closing, reimbursing the buyer directly may avoid boot.

 

Another Boot Avoiding Measure: Refinance

To repeat: any cash taken out at closing and any debt that is not covered could be subject to tax. No way around that. So, are there other ways you could take cash off the table in advance of your §1031 exchange?

What if you were to refinance a property before the 1031 exchange–pulling cash out–and then have more debt and less cash? Now post-exchange with no boot, you’re left with relinquished properties debt paid off. Yes, there’s more debt and lower equity in your replacement property but gains taxes are deferred (read more about this in our article Can I Get Cash Out of My 1031 Exchange?).

Too good to be true? Probably so. In this staged context the IRS may not buy it. But what if it doesn’t go down in lockstep and plausible business reasons exist for refinancing? Say, cash flow problems or storm damaged buildings have draining cash. Odds are better that refinancing will go unchallenged on an exchange.

Also, while there’s no IRS lapse-time safe harbor, the more time between the refinances and exchanges is better. Then again, some experts argue that with a solid business motive, no wait at all is necessary.

So, you go forward with refinancing. Post-exchange can you reverse the process, refinance the acquired property to pull equity out? The IRS seems okay with it–the thinking being perhaps– you’re keeping the cash but adding debt to repay in return.

Bottom line the consensus among experts seems to be: without an actual financial need, don’t refinance pre-exchange just to avoid boot, increasing tax deferrals. Refinancing your replacement property post-exchange is preferable.

 

Mortgage Boot

Mortgage boot may be avoided by ensuring that replacement property acquisition requires you to:

  • either enter a new mortgage equal to or greater than the relinquished property’s mortgage when sold or
  • elect to replace the previous amount of replacement property debt with an additional cash contribution.

 

That is, debt paid on relinquished properties must be replaced with a cash payment or replacement property debt of an equal or greater amount must be created.

For example, consider the scenario in the Examples section above. You paid off a $100,000 mortgage after the sale of the relinquished property. To follow the debt replacement principle, you must obtain a new mortgage for at least $100,000 or contribute at least $100,000 in cash.

Or you may apply some combination of financing and cash that totals $100,000 or more on the replacement property.

 

Personal Property Boot

As the heading implies, personal property is not like-kind real estate property. Any property not real estate included either in the purchase or sale is boot. You will need to plan ahead and work with those involved to handle such items separately prior to the §1031 exchange.

This may be done with a separate sales agreement listing all personal property excluded from the sale. Then during the exchange, check to ensure the listed properties are excluded.

 

Review of Boot Do’s and Don’ts

  • Unless you want cash and are willing to pay some taxes, avoid boot.
  • Don’t trade down, rather go even or up (even up) to avoid either cash or mortgage boot.
  • Avoid receiving non like-kind property.
  • Residual cash is boot so limit financing to amounts required for closing on replacements.
  • Look to pay exchange expenses pre-exchange to reduce or eliminate boot.
  • Have adequate outside cash at relinquished property closing for unrelated charges, as well.
  • Barring actual cash needs, undertake any refinancing on replacement properties post-exchange.
  • Mortgage placement costs such as replacement application fees and points aren’t routine acquisition charges and may create a taxable event.
  • Recent electric bills, repairs, et al, aren’t transactional expenses and will create a taxable event if paid out of exchange funds.
  • Prior to closing, you, any advisor, and the QI should carefully review closing statements to uncover any unwanted boot.
  • While QIs oversee all things §1031, you or your advisor should possess full exchange expertise to guarantee best outcomes.

 

Finally, speaking of outcomes, be sure you’ve set realistic tax deferral goals, verified by a qualified professional as needed. You’ll want to be sure that taxable boot stays in check, making your time and effort well worth it.

 

How to Ensure Your Exchange Is Legal and Safe?

Unless you are conducting a simultaneous exchange that doesn’t involve boot, you must use services of a qualified intermediary. A professional, competent, and experienced 1031 exchange company with income tax experts on the team will advise you on the options you have to minimize your boot while getting the most of your relinquished property value. They will ensure that the procedure is completed legally, in compliance with all IRS rules.

PropertyCashin is an all-in-one platform for commercial real estate investors that maintains relationships with top-rated 1031 exchange firms in all locations of the USA. To get connected with the best professionals and have your exchange processed safely and effectively, fill out the form below.

About the Author
Sam McGrath

As the Lead Commercial Real Estate Analyst at PropertyCashin, Sam McGrath is responsible for the company’s national sales strategy. Prior to his position with the company, Sam served as a Surface Warfare Officer in the United States Navy. Further, Sam was the National Recruitment Manager at Maxim where he expanded the Maxim healthcare brand nationally. He has over 8 years of experience in creative real estate investing. In addition, Sam has bought and sold commercial and residential property in over 42 states. Sam has a bachelor’s degree in business administration and marketing from Texas State University.

Recent Articles
How to Invest in Commercial Real Estate: Guide to CRE Investing for Beginners
Read More
1031 Exchange with Multiple Relinquished or Replacement Properties Involved
Read More
How 1031 Exchanges Work for LLC, Partnerships, Trusts, and Corporations with Partial Interest in the Property
Read More
All You Need to Know About a Partial 1031 Exchange
Read More
Delayed (aka Starker or Forward) 1031 Exchange Explained A-to-Z
Read More
Can You Do a 1031 Exchange and Avoid Depreciation Recapture?
Read More
Is Leaseback of Commercial Property a Good Idea?
Read More
A-to-Z Guide to Delaware Statutory Trust (DST) 1031 Exchange
Read More