What Qualifies as “Boot” in a 1031 Exchange?

Conducting a 1031 exchange provides the ability to indefinitely defer federal tax liability on realized gain from the sale of an appreciated piece of real estate. However, this indefinite tax deferral only applies to sale proceeds used to acquire “like-kind” property. It does not apply to “boot.” What is boot, and how can you avoid boot-related tax in a 1031 exchange? Our 1031 exchange specialists explain:

Understanding What Constitutes “Boot” in a 1031 Exchange

Boot from a 1031 exchange can take many different forms. Ultimately, if a U.S. taxpayer conducting a 1031 exchange receives anything of value that it does not subsequently reinvest into a qualifying replacement property, this can trigger immediate federal tax liability.

With this in mind, some common examples of boot received in 1031 exchanges include:

• Cash proceeds not used for the purchase of a qualifying replacement property
• Other proceeds that do not qualify as like-kind property (i.e., securities and notes)
• Debt relief (i.e., assumption of the mortgage on a relinquished property)
• Personal property received in the transaction (i.e., equipment and machinery)
• Other property that is not intended for investment or business use

Crucially, if a taxpayer receives cash proceeds from the sale of a relinquished property directly, these cash proceeds are treated as boot even if the taxpayer subsequently acquires a replacement property. As discussed in greater detail below, this makes it critical to work with a qualified intermediary when conducting a delayed exchange.

How Can You Avoid Receiving Boot in a 1031 Exchange?

While receiving cash or eliminating debt can be advantageous in some circumstances, many taxpayers will prefer to completely avoid boot when conducting a 1031 exchange. This maximizes the indefinite tax deferral resulting from the exchange, and this, in turn, maximizes the amount taxpayers can reinvest in one or more replacement properties.

How can you avoid receiving boot in a 1031 exchange? Here are three key strategic considerations:

1. Acquire One or More Replacement Properties with a Total Value Exceeding the Sale Price of the Relinquished Property

Acquiring a replacement property worth less than the taxpayer’s relinquished property will invariably trigger boot in a 1031 exchange. As a result, when seeking to avoid boot, taxpayers should acquire one or more replacement properties with a total value exceeding the sale price of their relinquished property.

When conducting 1031 exchanges, taxpayers should also ensure that their replacement properties qualify for like-kind exchange treatment. As noted above, personal property received in a 1031 exchange will generally be treated as boot—because personal property is not considered of “like kind” with real estate. Likewise, under Section 1031 of the Internal Revenue Code, like-kind exchange treatment is only available for properties acquired for investment or business use. As a result, if a property will be used for personal purposes (or flipped), then Section 1031 does not apply.

2. Transfer All Equity in the Relinquished Property Into the Replacement Property (or Properties)

In this same vein, taxpayers seeking to avoid boot in a 1031 exchange should transfer all of their equity in their relinquished property into their replacement property (or properties). If a taxpayer uses a portion of the equity in a relinquished property for other purposes (i.e., to pay off a loan), this portion of the taxpayer’s equity can be classified as boot.

3. Work with a Qualified Intermediary to Avoid Receiving Sale Proceeds for the Relinquished Property Directly

As we mentioned above, if a taxpayer comes into direct possession of the sale proceeds from a relinquished property—even temporarily—the proceeds will be classified as boot. To avoid coming into direct possession of the sale proceeds, taxpayers can work with a qualified intermediary.

A qualified intermediary holds the funds involved in a delayed exchange until they can be used for the acquisition of a replacement property (or properties). This avoids boot classification and immediate federal taxation. Qualified intermediaries can offer a variety of other services as well, and working with an experienced qualified intermediary can help maximize all of the benefits of conducting a 1031 exchange.

Contact the 1031 Exchange Specialists at 1031 National Services

At 1031 National Services, we serve as qualified intermediaries for 1031 exchanges nationwide. If you would like more information about what you need to do in order to avoid receiving boot in a 1031 exchange, we invite you to get in touch. Call 888-872-1031 or contact us online to schedule a free consultation with one of our 1031 exchange specialists today.