Partial 1031 Exchanges and Boot: What You Need to Know

Conducting a 1031 exchange allows you to indefinitely defer tax liability on capital gains from the sale of the relinquished property. But, this assumes two things: (i) that you conduct your 1031 exchange appropriately and (ii) that you reinvest all of the proceeds from the sale into a like-kind property. So, what happens if you don’t want to reinvest all of the proceeds? In this scenario, you can work with a 1031 qualified intermediary to conduct a partial exchange.

What Is a Partial 1031 Exchange?

A partial 1031 exchange involves selling a piece of real estate and then reinvesting a portion of the proceeds into another property. The fundamentals are the same as a full 1031 exchange, and investors seeking to conduct partial 1031 exchanges must comply with the same provisions of the Internal Revenue Code (IRC).

Here’s an example: Let’s say you have a property that you bought for $1 million, and you sell it for $1.2 million. Working with your 1031 qualified intermediary, you timely identify and purchase a replacement property that costs $1 million. This is a partial 1031 exchange that leaves you with a $1 million investment property and $200,000 in “boot.”

What Is “Boot?”

“Boot” simply refers to the proceeds of a sale that you do not reinvest when conducting a like-kind exchange under Section 1031 of the IRC. While boot can be cash, it can take other forms as well. For example, the following can all potentially constitute boot in a partial 1031 exchange:

• Debt reduction (i.e., paying off a mortgage and acquiring a smaller loan for the replacement property)
• Loan acquisition costs for the replacement property
• Rent prorations, tenant damage deposits and other non-closing-related costs
• Excess borrowing when acquiring the replacement property
• Non-like-kind property exchanged for the relinquished property

While investors may intentionally conduct partial 1031 exchanges resulting in boot in order to free up cash or reduce their debt load, investors who aren’t careful can also receive boot unintentionally. As we discuss below, this can result in unintended tax liability.

Understanding the Tax Implications of Boot

When you receive boot through a partial 1031 exchange, the boot is taxable. Any tax owed on proceeds reinvested in a replacement property is still deferred indefinitely, but any tax owed on the boot is not. So, in our example above, since the entire $200,000 gain is boot, this means that you would not benefit from conducting a 1031 exchange.

But, let’s say that instead of buying a replacement property for $1 million, you buy a replacement property for $1.15 million. In this scenario, your boot would only be $50,000. You could still defer tax on $150,000 in capital gains, and you would only owe tax on the $50,000 that you didn’t reinvest in a like-kind property.

As you can see, the tax implications of boot can have a significant impact on the desirability of conducting a 1031 exchange—and these implications are important to consider when choosing a replacement property and weighing the benefits of cashing out or reducing debt through a like-kind exchange. An experienced 1031 qualified intermediary can help you make informed decisions and can help you determine if you have options for avoiding capital gains tax on any boot as well.

Options for Avoiding Capital Gains Tax on Boot

While receiving boot in a like-kind exchange triggers capital gains tax liability, there are options for avoiding this liability while still achieving your goals in many cases. For example, by working with an experienced 1031 qualified intermediary, you may be able to:  

• Do a Cash-Out Refinance – If one of your goals is to generate cash from the sale of your relinquished property, rather than receiving boot, you may be able to do a cash-out refinance on your replacement property after closing.
• Invest in a Delaware Statutory Trust – If you are having trouble finding a suitable replacement property that equals or exceeds the value of your relinquished property, investing in a Delaware Statutory Trust may allow you to acquire a fractional interest in another like-kind property in order to avoid boot.
• Leverage Your Carryforward Losses – If you have carryforward losses from a previous transaction, you may be able to use boot to claim these losses and offset the capital gains tax that you would otherwise owe.

Schedule a Free Consultation with a 1031 Qualified Intermediary Today

Do you have questions about conducting a partial 1031 exchange? If so, we invite you to get in touch. Call 888-872-1031 or contact us online to schedule a free consultation at 1031 National Services.