Last updated on April 3rd, 2020 at 09:44 pm
If you’re thinking about a 1031 exchange or in the middle of one, you’ve probably heard the term “boot.” Boot is simply the portion that will be taxed after your partial 1031 exchange. Since the whole point of the 1031 is to defer taxes, boot is usually considered a bad thing. While no one wants to pay more taxes than necessary, boot is sometimes a necessary evil when searching for replacement properties. Other times, boot can be a source of cash, and the investor is happy to pay taxes in order to free up capital.
In this article, we explain what boot is in greater detail, and show you how to avoid boot. Then, we’ll walk through the two types of boot, “mortgage boot” and “cash boot.” We’ll talk about examples where it does not make sense to do a 1031 exchange, since you’ll have so much in boot. Then, we’ve provided a 1031 exchange boot calculator to test it for yourself. Last, we’ll finish with a few partial 1031 exchange boot examples and answer some frequently asked questions.
What is Boot in a Partial 1031 Exchange?
A partial 1031 exchange occurs in two scenarios. The first is when you receive cash during or after an exchange, because you did not fully invest the proceeds in the new property. This results in cash boot. The second is when the mortgage paid off by the sale of the old property is greater than the mortgage on the new property being taken over. We’ll dive deeper into both scenarios.
This is when the value of the new property (also known as replacement property) is less than the value of the old property (also known as the relinquished property). For example, if you sold a property for $400,000, then bought a replacement property for $300,000, this is a partial 1031 exchange. Because you need to reinvest all of the proceeds from a sale in a like-kind property to defer all taxes. The $100,000 remaining is considered cash boot. Cash boot is taxable when you receive cash at the time of sale of the relinquished property.
You may also have boot if you have an amount still left on a mortgage. Let’s say you own a property worth $500,000, and there’s $100,000 left on the mortgage. If you buy a replacement property for $500,000 and only have $200,000 left on the mortgage, you will have $100,000 in mortgage boot. This is because you cashed out $400,000 from the sale, and only reinvested $300,000 in the new property. Mortgage boot is usually taxable.
How to Avoid Boot During a 1031 Exchange
If you purchase a new property that is equal or greater value than the net sale price of your existing property, and also you spend all of the old property proceeds buying the new property, then your exchange will be completely tax-free. If you follow this rule, there will not be any cash boot received. As long as the mortgage you take on is greater than the old property mortgage, you will not have any taxable mortgage boot.
That said, sometimes boot is less of a bug, and more of a feature. If you’ve gained a large amount of equity in your real estate holdings, and need the cash, taking some boot can be a good thing. For example, if you have upcoming childcare or school expenses, a partial 1031 exchange can help you cash out some.
Things to Avoid During Partial 1031 Exchange
Partial exchanges are relatively common, but there are scenarios when a 1031 exchange is not suitable for you. For example, you can only start to defer taxes once you’ve acquired the new, replacement property and its value is greater than the old property. If you receive cash boot, however, before doing your exchange, you may be in trouble. There are scenarios where a taxpayer pays tax on the boot that is close to the tax due without a 1031 exchange.
That would no be ideal. Imagine paying a qualified intermediary for their services, identifying and closing on a replacement property, only to discover you haven’t saved much money by doing a 1031 exchange.
In addition to working with a qualified intermediary, we highly suggest contacting a tax professional as well. They can help determine the taxes that will be due without a 1031 exchange. Then, you can see how much you’ll save during the process. Since 1031 exchange companies are interested in doing as many exchanges as possible, it’s important to get a third party opinion. Especially for exchange companies that are owned by large, publicly traded companies. They’re not in the business of stopping your exchange!
Partial 1031 Exchange Calculator
Partial 1031 Exchange – Boot Examples
If you’re still not getting it, we’re going to walk through a few examples. Hopefully you will be able to relate these to your situation. If it still doesn’t click, we recommend talking to a tax professional or a qualified intermediary.
Partial 1031 Exchange FAQ
Can you do a partial 1031 exchange?
The long answer is above, and the short answer is YES. If you need to cash out a portion of your proceeds for a life event, a partial 1031 exchange allows you to do so. It can also help to find the exact replacement property you need. It’s better to buy a great property that incurs some taxes than a bad, expensive, levered property.
What qualifies as a 1031 exchange?
Any real estate transaction where you sell one property, and exchange it for a like-kind within a certain timeframe.
How is boot taxed in a 1031 exchange?
It is taxed in three different brackets, depending on the type of gain.
Excess depreciation recapture is taxed at personal income rates. If you’re not familiar with this, it applies to properties that have been depreciated faster than the straight line method over a 39 year period.
Regular depreciation recapture boot is taxed at a flat rate of 25%.
Any capital gains boot is taxed at 15% usually.
This can get confusing, fast. We highly recommend reaching out to a tax professional if you have more than one type of “boot.”