A like-kind or 1031 exchange is a powerful tax strategy to create enormous wealth over an investor’s lifetime. We discuss the rules regularly here in this forum, but one of the most common questions that causes confusion is the concept of “boot.”
Let’s start with the basics, what is boot? Most of us have traded in a car in our lifetime and, unless you’re lucky or the car dealer is foolish, the equation runs something like this: [old car] + $ = [new car]. You trade in the old car, add some money either by check or through a car loan, and you “exchange” your car for a new one. That money “added” to the deal is boot.
A real estate exchange is no different. Sure, every once in a while someone trades their house in an even exchange for another. But more likely, the relinquished property (the one you’re selling) and the replacement property (the one you’re buying) are of different value. A fundamental rule of a proper forward 1031 exchange is that the exchanger cannot receive boot in the transaction. If the exchanger does receive boot, there may be applicable tax.
But there are a few ways to receive boot, and that’s where it gets tricky.
Cash boot: This is the easiest to understand. Suppose the taxpayer sells the relinquished property for $1,000,000. The taxpayer decides to keep some of the proceeds for personal use, takes $100,000 of the proceeds and spends it on a car. That is, in its simplest form, “cash boot” and tax must be paid on this amount.
Debt reduction boot: Also known as “mortgage boot”, this occurs when the debt on the replacement property is less than the debt on the relinquished property. Let’s take an example. Taxpayer sells property for $1,000,000 which has a $500,000 remaining mortgage on it. The taxpayer buys a replacement property for $1,000,000, but finances only $300,000 on the replacement property. The taxpayer does this by adding cash of $200,000 to the transaction. In this example, the taxpayer “received” mortgage boot of $200,000 and “gave” cash boot of $200,000. So is that a wash?
The rules of netting boot: Stay with me here, because this is where we start to get a little advanced. The rules of netting boot are as follows: (1) cash boot paid offsets cash boot received at the same closing transaction, (2) cash boot paid offsets mortgage boot received, (3) mortgage boot paid offsets mortgage boot received, BUT (4) mortgage boot paid does not offset cash boot received. Huh?
Let’s take each rule by itself.
(1) Cash boot paid offsets cash boot received: Bob puts down $100,000 as a contract deposit for the replacement property from his own funds. At closing, the proceeds from his relinquished property are used to acquire the replacement property, and as a result he gets back $100,000 at closing, as earnest money reimbursement. That is cash boot. But the boot received is offset by the boot paid (the $100,000 he put down) so these net out.
(2) Cash boot paid offsets mortgage boot received: Bob sells his property for $1,000,000, which had $500,000 in mortgage owed. He buys a replacement property for $1,000,000, but pays all cash for this property. He has “received” $500,000 in mortgage boot, and “paid” $500,000 in cash boot, so these two can be netted based on rule 2 above.
(3) Mortgage boot paid offsets mortgage boot received: Bob sells his property for $1,000,000 which had $500,000 in mortgage owed. He buys a replacement property for $1,000,000, and finances $500,000 with a new loan. In this case he paid $500,000 in mortgage boot with the new loan, and received $500,000 in mortgage boot by paying off the existing load at the closing, so these will net each other and under rule 3 above, they can offset each other.
(4) Mortgage boot paid does not offset cash boot received: Bob sells his property for $1,000,000 which had $500,000 in mortgage owed. He buys a replacement property for $1,000,000, but finances $700,000 in a new loan and receives at closing $200,000 back . Bob “paid” $200,000 in mortgage boot because his loan increased, and “received” $200,000 in cash boot because he got cash back at closing, but these cannot be offset against each other based on rule 4 above since mortgage boot paid cannot offset cash boot received, and accordingly he will be liable for tax on the cash boot.
How to avoid boot in a 1031 exchange?
The best way to avoid boot in a 1031 exchange is to reinvest all of the proceeds from the relinquish sale into the replacement property, and ensure that the new mortgage is equal or less than the old mortgage amount. Also, have your qualified intermediary review your settlement statements for “hidden” boot. Don’t inadvertently receive boot.