Not to familiar with 1031 Exchanges? Read our 1031 Exchange Guide.
What is a 1031 exchange boot?
Contrary to a somewhat popular misconception, a 1031 exchange isnt an all-or-nothing proposition. Its possible to conduct a successful 1031 exchange, but still owe some capital gains tax on the transaction when this happens, the taxable portion of the deal is known as a boot.
While some exchangers will consider it a worthwhile trade-off to pay some tax in exchange for cashing out equity, the goal of most 1031 exchanges is to defer all taxes on the transaction. To accomplish this, you must understand the scenarios that generate boot and how to avoid them.
The simplest type of 1031 exchange boot: cash boot
Many people believe that Section 1031 requires the replacement property to be worth at least as much as the relinquished property. However, while this is usually desirable, it isnt a requirement, unless the exchanger wants to avoid all taxes.
Lets say you sell your existing property, on which you carry no mortgage, for $500,000, and you buy your replacement property for $400,000 (and no mortgage). As long as all other qualification criteria are met, you can still complete a 1031 exchange but only part of the gain on the sale will qualify for tax deferral. In this case, you will be left with $100,000 gain due to cash boot, which will not be covered by the exchange, and will therefore be taxed.
(In this scenario, you may be able to invest the difference in a second property, such as a DST interest, to avoid taxation.)
The replacement property is more valuable, but I still owe taxes?
The preceding figures assume an all cash exchange. Things become slightly more complicated when mortgages are involved.
Consider an exchange scenario in which you sell relinquished property valued at $500k, with an existing mortgage of $350.000, which is repaid in full at closing. You then acquire a replacement property valued at $600,000 and make a 20% cash down payment meaning that the new mortgage on the replacement property is $480,000. In this case, you have taken $150k in equity out of the relinquished property, and only reinvested $120,000. Youve effectively cashed out $30,000 in equity, creating a net taxable cash boot even though the replacement property value was higher.
The debt relief boot
Just as you must avoid cashing out equity, you must also avoid reducing your debt obligations in a 1031 exchange.
Consider this scenario: You sell relinquished property valued at $500,000, with existing mortgages of $350,000. You then acquire replacement property valued at $450,000, and you know from the example above that you need to reinvest all of your equity ($150,000) into the new property, so you take out a mortgage of $300,000.
In this case, even though you rolled all of your equity forward, you have benefitted from debt relief in the process ($300,000 vs. $350,000), so youve generated $50,000 boot.
Note that you can reduce your debt obligation and still defer tax, but you need to offset it by adding cash . If in the case above the replacement property was valued at $500,000 (instead of $450,000) you could take out the same mortgage of $300,000, but offset the $50,000 in debt relief ($300,000 vs. $350,000) by adding $50,000 cash to the purchase to offset the net debt relief.
Want a completely tax-free 1031 exchange?
If your goal is a 100% tax-free 1031 exchange, be sure to engage a 1031 qualified intermediary (QI) with a proven track record your QI should help you carefully structure your exchange to avoid surprises.
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What can we help you exchange?
At JTC Americas, weve put together an industry-leading track record of 1031 success, across tens of thousands of transactions and more than 25 years in the business. Members of our legal and Client Services team have decades of experience handling 1031 exchanges. Weve built a cutting-edge administration platform, called eSTAC®, from the ground up to maximize your transaction security and transparency.
If youre considering a real estate exchange, youve come to the right place. Schedule a free consultation (with no obligation) by filling out the form below!