Understanding how capital gains are accounted for in a 1031 exchange is a key part of planning. When done well, all gains can be deferred, otherwise you can end up with “Taxable Boot”.
In a 1031 exchange, “boot” refers to any leftover sale proceeds subject to tax. This can take many forms, including cash that is not re-invested, non-like-kind real estate received in the exchange, debt relief, or other property. Boot is just another term for capital gains as they relate to a like-kind exchange, but they have a very specific formula.
Boot can be tricky to calculate because there are two parts - “Cash Boot” and “Mortgage Boot” - which translate to a total boot amount. We’ll break down how to calculate the different types of taxable boot below.
What is “Boot” in real estate?
Like-kind exchanges have an interesting history that’s rooted in trading live-stock. In historical bartering systems, when two parties exchanged goods, one party might add something extra to make the trade fair if the items being exchanged were not of equal value. For example, if someone traded a horse for a cow, but the horse was deemed more valuable, the person receiving the cow might also give some cash or another item to balance the trade. Like any good cowboy, they extra cash was often tucked into their cowboy boots, and the term “boot” was born.
Calculating Cash Boot in a 1031 Exchange
Cash boot is anything of value that is leftover once the exchange is complete. The most straightforward example is when cash proceeds from a sale aren’t reinvested into the replacement property, that incremental money is considered “cash boot” and is taxable.
This can occur if the replacement property costs less than the relinquished property, or if there are leftover funds after the purchase of the replacement property. For example:
- You sell a property for $500,000.
- You purchase a replacement property for $450,000.
- The $50,000 difference is considered cash boot.
Closing costs, expenses, and cash boot
Another common example, if non-qualifying expenses are paid with proceeds from the sale of the property being exchanged, that can trigger cash boot. Typical transaction costs won’t trigger boot, like title and escrow fees or brokerage commissions. But expenses such as security deposits, repair costs, and prepaid rent can generate boot if they are not properly allocated. So think twice before paying or receiving credits as part of your escrow and make sure you are reviewing your settlement statements.
Non-cash boot
There are also non-cash items that can trigger cash boot in an exchange (I know, I’m sorry!) But remember, “boot” is just anything of value you received outside of the exchanged property. For example, say sold a property worth $2,000,000 for $1,200,000 plus a 1952 Ferrari 212 Barchetta. While you can reinvest the $1,200,000 cash into replacement property, that Ferrari is going to be considered “cash boot” (for a bunch of reasons) and the value will be taxed.
Here are some examples of cash boot
- Property intended for personal use - For example, trading a real estate investment for a home you intend to live in.
- Real property exchanged for personal property - For example, the Ferrari trade mentioned above.
- Cash proceeds remaining after the exchange ends - For example, if the relinquished property had net proceeds of $100,000, but only $90,000 was reinvested and the remaining $10,000 was distributed to the investor.
- Cash proceeds received after closing on the replacement property - For example, say a sale of commercial real estate included a bonus payment based on some lease renewal that was paid after the exchange was completed.
- Non-qualified property, such as bonds, stocks, or partnership interests - For example, similar to the Ferrari trade above, but trading for Nvidia stock instead of a classic car.
Calculating Mortgage Boot in a 1031 Exchange
Mortgage boot occurs when the mortgage on the replacement property is less than the mortgage on the relinquished property. Essentially, if you are relieved of more debt than you take on, the difference is considered boot. To expand on our basic example from above:
- You sell a property for $500,000, with a mortgage of $300,000, and receive $200,000 in cash proceeds.
- You purchase a replacement property for $450,000, reinvesting the $200,000 proceeds from your sale and taking a mortgage of $250,000.
- The $50,000 difference in mortgage amount is considered debt relief, and that value is considered mortgage boot.
What if you don’t want to replace the mortgage? There is one other option to offset mortgage boot and avoid a taxable gain. You can replace the differences in the mortgage amounts with an additional cash investment. By investing an incremental amount into the replacement property, the mortgage is considered “replaced” and there is no relief.
Again, extending our example from above:
- You sell a property for $500,000, with a mortgage of $300,000, and receive $200,000 in cash proceeds.
- You purchase a replacement property for $500,000, reinvest the $200,000 proceeds from your sale, taking a mortgage of $250,000 and making an additional investment of $50,000 (for a total of $300,000).
- The $50,000 difference in mortgage amount is considered debt relief, and that value is considered mortgage boot.
One way to think about this is that it’s the same as if you were to pay down the mortgage prior to selling the relinquished property, reducing the outstanding balance you’d have to replace to complete the exchange.
While the concept behind mortgage boot is simple in theory, and the formula is much more straight forward, in practice it can be difficult to track and account for during an exchange. Check out our article on 1031 exchange rules to learn more about the requirements for replacing a mortgage or visit our exchange calculator to run some scenarios.
Calculating Total Boot
To determine total boot in a 1031 exchange, you can add together Cash Boot and Mortgage Boot.
Imagine you are selling a commercial property for 1,000,000 with a mortgage of 400,000. You find a replacement property for 950,000 with a mortgage of 350,000. Here’s how you would calculate boot:
- Cash Boot: 1,000,000 (sale price) - 950,000 (purchase price) = $50,000.
- Mortgage Boot: 400,000 (old mortgage) - 350,000 (new mortgage) = $50,000.
- Total Boot: 50,000 (cash) + 50,000 (mortgage) = $100,000.
In this scenario, you would have $100,000 of boot, which would be subject to capital gains tax.
How to Minimize Boot in an Exchange
When planning a 1031 exchange, there are a few basic guides you can follow to avoid boot and fully defer your capital gains. The easy way to think about this is you want to trade “Equal or Up”.
- Match Property Values: Ensure the replacement property is of equal or greater value than the relinquished property. This will help avoid any cash boot from the differences in sale price.
- Match Debt Levels: Take on a mortgage on the replacement property that is equal to or greater than the mortgage on the relinquished property. This will help avoid any mortgage boot.
Conclusion
Understanding boot is key to deferring as much taxable gain as possible in a 1031 exchange. By carefully managing the sale and purchase prices, mortgage amounts, and handling prorations correctly, you can minimize or even eliminate boot. If you want to learn more about boot, or ask a question about your specific situation, check out our free online tax expert ARTE and get an instant answer to your question.
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