What is Boot in 1031 Exchanges What is Boot in 1031 Exchanges
A 1031 exchange is a great way for real estate investors to defer capital gains tax on property transactions by selling an investment property and purchasing a like-kind replacement property. Section 1031 of the U.S. Tax Code provides investors with an invaluable path to potential wealth building, but the process can be complicated, which makes working with a Qualified Intermediary like Leader1031 all the more necessary when navigating a 1031 exchange.
One of the concepts your Qualified Intermediary will help familiarize you with when completing a tax-deferred exchange is “boot”. As mentioned above, a 1031 exchange broadly involves the sale of an investment property in exchange for the purchase of a like-kind property or properties. Boot refers to any non-like-kind property received in an exchange. Below we'll explore what boot is in a 1031 exchange, some common examples of boot, and how to avoid boot in a like-kind exchange.
What is Boot in a 1031 Exchange?
As mentioned above, the term boot generally refers to any property received in a 1031 exchange that is not considered to be like-kind. You may be wondering how this is possible given that we just defined a 1031 exchange as the sale of an investment property and purchase of a like-kind replacement property to defer capital gains tax -- a totally fair question. The answer may be more straightforward than you think – one reason boot comes into play because it can be difficult to find a replacement property (or properties) that is of the same value of the property being relinquished. When this occurs, there may be proceeds from the sale that are received by the seller and not applied towards the purchase of the replacement property. These proceeds are taxable boot, not part of the exchange, and so subject to capital gains taxes from the sale. The important thing to note is that boot does not disqualify a 1031 exchange from taking place, it simply makes the transaction a partially deferred exchange meaning that any amount of realized gain from the sale of the relinquished property will be taxed while the amounts exchanged for like-kind property are deferred.
Key Takeaways:
- Boot generally refers to any non-like-kind property received in a 1031 exchange.
- One reason boot comes into play in an exchange because it can be difficult to find a replacement property (or properties) that is of the same value of the property being relinquished.
- When this occurs, there may be proceeds from the sale that are received by the seller and not applied towards the purchase of the replacement property.
- These proceeds are taxable boot, not part of the exchange, and so subject to capital gains taxes from the sale.
- Boot does not disqualify a 1031 exchange from taking place.
Common Examples of Boot in a 1031 Exchange
Boot can come in several different forms depending on the parties involved in any given exchange. The most common type of boot is cash boot, which can occur in different ways -- cash proceeds a taxpayer takes from escrow prior to any remaining funds being sent to their Qualified Intermediary, any funds remaining once the 1031 exchange has concluded, or funds received by the taxpayer during the closing of the replacement property. Another common type of boot is a debt reduction boot (also known as mortgage boot), which occurs when the debt on the replacement property in an exchange is less than the debt owed on the relinquished property at the time of sale. A third type of boot is personal property boot and it is pretty much exactly what it sounds like -- any personal property received as part of an exchange that is not like-kind to the real property sold through the exchange. For instance, real property being exchanged for personal property. Non-qualified property including stocks, bonds, and notes can also be classified as boot. These are just a few examples of common types of boot in a 1031 exchange. Please be sure to consult with your tax and legal counsel, and your Qualified Intermediary, to understand what could qualify as boot if you're interested in initiating an exchange.
How to Avoid Boot in a 1031 Like-Kind Exchange
It bears repeating that the first step you should take if you're contemplating a 1031 exchange is to reach out to a Qualified Intermediary, like the team at Leader1031. Your QI will be able to help you navigate the intricacies of your exchange. There are a few scenarios in a 1031 exchange where investors won't generally have to worry about boot. The first is if the value of a like-kind replacement property in an exchange is of equal or greater value than the relinquished property. The second scenario where investors won't generally have to worry about boot in a 1031 exchange is if they obtain debt on the replacement property that is equal to or greater than the debt that existed on the property they sold as part of the exchange. The third scenario where investors shouldn't encounter boot in a 1031 exchange is if they choose to reinvest the net equity from the sale of their property into the replacement property.
How Real Estate Investors Can Get Started With a 1031 Exchange
The first step investors should take when exploring the benefits of a 1031 exchange is ensure they have surrounded themselves with the appropriate team of professionals to guide them through the process including a tax advisor, realtor, attorney, and Qualified Intermediary.
Finding the right qualified intermediary to work with is crucial to the 1031 exchange process because it helps verify the security of your funds and provides your entire team with knowledge and experience that they might not otherwise have.
Your qualified intermediary will interact with your realtor, tax advisor, escrow professional, attorney, and representatives for the property you are purchasing, so it's extremely important to make sure you choose a QI who can guide your team through the complexities of the process while meeting all of the important associated deadlines.
Leader Bank's 1031 exchange subsidiary, Leader1031*, serves as a qualified intermediary for real estate investors seeking to sell and purchase property using the tax-deferred advantages of a 1031 exchange. These services provide greater integration and efficiencies for our commercial real estate clients, and Leader1031 is committed to providing the highest quality of service.
As soon as your relinquished property has gone into contract, you can set up a 1031 Exchange account with Leader1031. This 1031 Exchange account and certain documentation provided by your QI must be in place prior to the close of your relinquished property sale.
Leader1031 is ready to help ensure your transactions are in full compliance with IRS Code Section 1031. Contact Leader1031 today.
It is imperative that you also consult with your own tax and legal counsel. Leader1031 is prohibited from providing tax and legal counsel as a qualified intermediary under the IRS Code Section 1031.
The content of this publication is provided as general information only and should not be taken as legal, investment or other professional advice. This content of this publication shall not be construed as a recommendation to participate in any particular trading, financial or investment strategy, and neither Leader Bank, NA nor Leader1031.com, LLC can provide legal or tax advice concerning the specific tax consequences of a given transaction. Any action that you take as a result of information or opinions provided in this publication is ultimately your responsibility. Consult your attorney, accountant, or tax professional before making any investment or financial decisions.
To ensure compliance with requirements under Treasury Department Circular 230, we inform you that the contents of this publication are not intended or written to be used, and may not be used, for the purpose of (i) avoiding U.S. federal tax penalties or (ii) promoting, marketing, or recommending to another party any matter addressed herein. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax adviser.
