How you can adjust the leftover boot and successfully complete your 1031 exchange?

Section 1031 of IRC, popularly known as a 1031 exchange, allows investors to defer capital gains tax on exchanging an investment property for another like-kind property. The term like-kind is used to define properties that are similar in nature. For example, using a 1031 exchange, an investor can exchange an investment property for any other investment property. Both the relinquished and replacement properties just need to be like-kind and needn’t serve the same purpose. An investor must abide by the rules set up the IRS in order to successfully qualify for a 1031 exchange.

1031 Exchange Rules -

No matter how easy a 1031 exchange may appear, it certainly requires proper handling. It’s important that every 1031 exchange is completed in accordance with the guidelines set up by the IRS, as even a slight mistake can eliminate the possibility of tax deferment. Here are the rules for doing a 1031 exchange –

  • An investor must involve a Qualified Intermediary in the exchange. A 1031 exchange is impossible without the participation of a Qualified Intermediary.
  • Properties involved in 1031 exchanges must be like-kind.
  • The value of the replacement property must be equal to or greater than the value of the relinquished property.
  • A 1031 exchange investor must identify a potential replacement property within 45 days (starts from the day the relinquished property is sold).
  • Every 1031 exchange must be completed within 180 days (starts the day the relinquished property is sold).
  • A 1031 exchange investor is not allowed to touch the proceeds obtained from the sale of their relinquished property. All funds should be held by the Qualified Intermediary in a separate account.

What happens if the price of the replacement property is less than that of the relinquished property?

There could be a situation where the cost of the replacement property is less than that of the relinquished property. Well, this can result in a ‘Boot’. A boot is generally defined as ‘the cash received’ by the investor at the end of a 1031 exchange. It’s the difference between the costs of the relinquished and replacement properties. Recognition of boot can immediately make a 1031 exchange invalid and eliminate the possibility of tax deferment. However, it’s difficult to calculate everything in advance and 1031 exchange investors often face difficulties in adjusting leftover boot. Here are some tips on how you can adjust leftover boot in a 1031 exchange after purchasing the replacement property –

Let’s assume you had an investment property that you sold for $2 million. As per the rules, you must acquire a replacement property of same or greater value in order to qualify for a 1031 exchange. However, the replacement property that you’ve identified costs $1.5 million and after acquiring it, you’re left with $50k, which qualifies as ‘boot’. Now, you must utilize this boot in order to successfully complete your 1031 exchange or else your proceeds will be taxed. There are a few options using which you can utilize this boot –

  • You can invest $50k in a DST and acquire its shares. Since DST shares are offered as real estate securities to 1031 exchange investors, doing so will save your 1031 exchange. Therefore, at the end of your exchange, you’ll have a property of value $1.5 million plus DST shares worth $50k.
  • You can invest $50k in another asset (not personal properties) and acquire it as your 1031 exchange replacement property. Using the ‘Three-property rule’, an investor can identify up to three replacement properties irrespective of the price. Not all the identified properties need to be acquired and it entirely depends upon the investor whether they want to acquire one, two or all three identified properties.
  • You can also invest $50k for carrying out some improvement works in your replacement property. A built-to-suit or improved exchange allows investors to use a part of their proceeds for carrying out minor repairing or improvement works in the replacement property. However, all kinds of improvement works must be completed before acquiring the replacement property. In case, you have already acquired your replacement property, consider this option invalid.

Depending upon the situation, a 1031 exchange investor can use any of the above-mentioned options to adjust the leftover boot and successfully complete their 1031 exchange.

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