The 1031 Exchange Boot
While section 1031 of the IRS offers excellent opportunity for the real estate investors by means of deferred tax exchange, the investors need to be careful about getting a 1031 exchange boot with which they might still end up with a tax bill.
Under the 1031 exchange rules, only like-kind property held for business qualifies for a 1031 exchange. Now, there are a number of things that, if included as a part of the exchange, can trigger a capital gain tax bill on the portion of the exchange that they represent. These are called 1031 exchange boot.
1031 exchange boot includes any item included in the trade that is not of like kind as defined under section 1031 of the IRS. Quiet often people get these boots included in their 1031 exchange and ends up with a capital gain tax bill for themselves.
The most common types of boot that real estate investors come across are:
a) Mortgage boot
b) Cash boot
There are also various other types of boots like personal property boot, personal residence boot etc.
Mortgage Boot: You get a mortgage boot on your 1031 exchange when the property you buy has a mortgage debt of lesser value than the mortgage debt on the property you are selling.
It is advised that the property you buy should have a mortgage debt equal to or greater than the property you are selling. In case the property you buy has lesser mortgage debt amount than the property sold in the 1031 exchange, the difference in the mortgage value will be taxable to you.
Avoid 1031 Exchange Boot – Way Around Mortgage Boot
If the seller of the property refinance the property and you assume the new higher debt. Alternatively, you can finance it through a new loan or a land-sale contract. You can add cash to the deal. Cash Added in offsets the debt relief on the property sold by you. Your 1031 exchange intermediary can advice you on this.
Cash Boot: Any cash or other cash equivalent value received (e.g. promissory note) in a 1031 exchange is also not included in like kind property and is considered as a cash boot. On any such income capital gain taxes are applicable and if the cash amount is a composite amount of any principal and interest, the capital gain taxes are charged on the principal amount. If this cash is retained for a longer period and you earn any interest from that, those interests will also be taxable as regular income.
Also, if the seller is paying cash for any repair charges that are required by the buyer then the amount paid by the seller towards repair charges is considered as a cash boot and is taxable.
Your 1031 exchange intermediary can advice you on how to avoid this type of 1031 exchange boot.
Personal Property Boot: Often an investment property would include appliances such a s washers. Dryers, refrigerators etc and if these items are included in the sale you can land up paying capital gain taxes for them. These are not like kind property.
These can very easily be avoided by clearly stating in the deed that appliances are not a part of the sale and you can always create a separate sale agreement for the appliances for one dollar. You can hide the actual price of the personal property (Appliances) in the sale agreement. You should ensure that these appliances are not included as a part of the real estate sale.
Personal Residence Boot: Investment property and personal residence property are not considered as like kind property. So if you are buying a four plex as a part of a 1031 exchange and then use one of the units as your personal residence then one quarter of the property would be considered as 1031 exchange boot and you will have to pay tax on that.
You can avoid this by waiting for the 1031 exchange to be completed and till the time you have paid the taxes for that year and after that you can move in to your new personal residence.
Dealer Property and Rental Property: Dealer property and often times rental property are not like kind property under section 1031 of the IRS. A dealer property is considered as an inventory where as most often a rental property is considered as an investment. If you are doing a 1031 exchange for a dealer property, it will not be a problem but the problem arises when you are disposing off a dealer property under section 1031.
Dealer property being legally termed as an inventory is not fit for an exchange. Though these type of exchanges take place, the IRS may always detect these under a close audit and in that case you will have to pay for taxes as well as penalties on the sale of the dealer property.
This document/post/article is not to be considered as legal advice. Content and information contained herein is subject to changes, modifications, and may contain inaccuracies or out-of-date information. As with any legal matter or other matters of importance, consultation with an attorney or professional is the best course of action.