Simplifying 1031 Exchange Boot: Tax Implications And Rules

To successfully complete a 1031 exchange and defer the taxes on your capital gains, you must sell your relinquished property and reinvest the entire proceeds in a qualifying replacement property. And while this all might seem simple, one thing that can make it challenging apart from the rules and timelines is avoiding boot. 

Wait, what is boot? 

Remember how we stated the term ‘entire’ proceeds? The boot is the amount you don’t reinvest. To make it simple for you, here’s an example. 

Say, you sold your relinquished property for $1 million. However, the replacement property you finalized is just for $900,000. So, if you reinvested your $900,000 in the replacement property, you would still be left with $100,000. This amount that you didn’t reinvest in a replacement property is called the boot. The boot is subject to capital gain taxes. 

But, the boot can happen in several other ways too. Read on to explore what boot is, why it is good for you and how to avoid paying taxes on it. 

How Does Boot Happen In 1031 Exchange?

There are several ways to create a boot. You can either create it on purpose or by accident. The boot usually happens in a partial 1031 exchange where you don’t reinvest some of your proceeds in a replacement property. 

Here are different ways through which the 1031 exchange boot can be generated. 

Cash Proceeds

The example stated above is a simple version of gaining boot in your cash proceeds. It simply occurs when you don’t reinvest a part of your cash proceeds in a new replacement property. Remember, the amount you didn’t reinvest, aka the boot, will be applicable to the capital gain taxes. 

Mortgage Reduction

Mortgage reduction can also generate boot. Here are the two ways through which it is possible-

  • The mortgage on your replacement property is less than the mortgage on your relinquished property. For instance, if you had a $200,000 mortgage on your relinquished property but only had a $100,000 mortgage on the new property, you will be generating a boot. 
  • Excess debt can also result in boot. For example, if both properties (relinquished and replacement) have a fair market value of $200,000 and you reinvested 100% of your proceeds, you’ll be fine so far. However, if the relinquished property had a loan of $90,000 and the new mortgage on the replacement property is $100,000, you’ll generate an additional $10,000 as boot. 

Non-Transaction Costs

If you invest a part of your proceeds on 1031 exchange non-transaction costs like renovation costs, prorated rent or tenant security deposits, you’ll be generating a boot on it. If you want to avoid it, make sure to bring extra cash during the closing and use your proceeds only for reinvesting. 

Non-like-kind Property Exchange

If you want to defer the taxes on your capital gains, you must only reinvest in a like-kind property. However, if you invest a certain part of your proceeds in a non-like-kind property, you would generate taxable boot. 

Personal Property

Stating again, you must keep your proceeds aside for reinvesting in a replacement property. If you spend it on your personal property like buying furniture or appliances, you will generate the boot. 

How To Avoid Boot?

Just like you can generate a boot in several ways, you can avoid it in several ways too. 

For starters, make sure to reinvest 100% of the proceeds in a like-kind investment property to successfully complete a 1031 exchange. Moreover, you must not use the proceeds for any other purposes like the loan closing or buying personal property. 

And, if you still have a boot in your transaction, you can invest in multiple properties. For instance, if you generated a 1031 exchange boot worth $100,000, you can invest the proceeds in a DST and defer the taxes. 

Boot Isn’t Always Bad- Wrapping Up

In fact, most investors deliberately create the boot. Why? Ell, it’s generally to cover their personal expenses. They reinvest a certain part of their proceeds and keep a certain part for their own expenses, even if they have to pay taxes on it. This is generally called a partial 1031 exchange. 

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