How Do You Deal with Boot in a 1031 Exchange?

Under Section 1031 of the Internal Revenue Code, like-kind exchanges involving qualifying real estate are eligible for indefinite tax deferral. However, this only applies to the proceeds from the sale of the “relinquished property” that are used for the purchase of the “replacement property.” Anything else received in connection with a like-kind exchange is classified as “boot,” and boot is not eligible for indefinite tax deferral under Section 1031. So, how can (and should) you deal with boot? A 1031 exchange expert at 1031 National Services explains:

Avoiding Boot in a 1031 Exchange

In many cases, the best way to deal with boot in a 1031 exchange is to avoid it entirely. However, this is often easier said than done. Boot can take many different forms, and once a taxpayer receives boot in connection with a 1031 exchange, it generally isn’t possible to have the boot reclassified as sale proceeds that are eligible for indefinite tax deferral.

Some examples of potential boot in a 1031 exchange include:

• Sale proceeds that are used to purchase property that does not qualify as replacement property
• Sale proceeds that are used to cover loan fees or other non-allowable expenses
• Non-real-estate assets included in the transaction (sale or purchase)
• Real estate assets included in the transaction that are not used for qualifying business or investment purposes
• The sale or purchase of anything else that does not qualify as “like-kind” property

In some cases, 1031 exchanges can involve “mortgage boot” as well. This occurs when the mortgage on the replacement property is less than the mortgage on the relinquished property. Even though this does not involve an exchange of funds, the IRS may still classify the reduction in debt as a form of taxable financial gain.

Broadly, avoiding boot (and immediate tax liability) in connection with a 1031 exchange involves structuring the transaction to ensure that the entirety of the sale proceeds are attributable to qualifying real estate and that the entirety of the sale proceeds are then reinvested in a qualifying replacement property. It is essential to work with an exchange facilitator during the process as well—as taking possession of the sale proceeds before acquiring the replacement property can also trigger immediate tax liability (regardless of any boot-related tax implications).

A common scenario that raises the possibility of immediate tax on boot is when one of the goals of conducting a 1031 exchange is to improve the replacement property with proceeds from the exchange. While holding sale proceeds in reserve to make improvements would ordinarily convert these proceeds into boot, it is possible to avoid this outcome by executing a build-to-suit exchange.

Dealing with Boot if You Can’t Avoid It

Now, what if you can’t avoid boot in a 1031 exchange?

If you can’t avoid boot in a 1031 exchange, then you will need to plan accordingly. You will need to thoroughly document the transaction and clearly identify all boot and non-boot proceeds, and you will need to be prepared to pay the IRS promptly. Failing to pay tax on boot when it is due will trigger additional liability for interest and penalties.  

Importantly, boot received in connection with a 1031 exchange can trigger either short-term or long-term capital gains tax depending on the circumstances involved. Short-term capital gains are taxed as ordinary income, while long-term capital gains are taxed at lower tax rates. This can have important planning implications as well—and, if you are considering a 1031 exchange with potential boot, it will be important to work with a 1031 exchange expert who can help you structure the transaction to minimize your immediate tax liability.

Ultimately, making informed decisions about how to deal with (or how to avoid) boot in a 1031 exchange requires an informed, proactive and strategic approach. When conducting a 1031 exchange, you should not receive boot as a surprise. If you thoroughly assess the potential tax implications of your proposed exchange, plan appropriately and work with a qualified exchange facilitator throughout the process, you should be able to move forward with a clear understanding of what you can expect going forward.

Discuss Your Options with a 1031 Exchange Expert at 1031 National Services

If you are considering a 1031 exchange and have more questions about boot (and its tax implications), we invite you to get in touch. To discuss your options with an experienced 1031 exchange expert at 1031 National Services, give us a call at 888-872-1031 or tell us how we can help online today.