Boot: The Part of a Fully Deferred Exchange That Is Still Taxable

Plenty of people finish a 1031 exchange, file the return and discover they owe tax anyway. The exchange did not fail. It was simply not complete, and the incomplete part has a name.

Boot is anything you receive in an exchange that is not like kind property. It is taxable in the year of the sale even when everything else about the exchange worked perfectly. Understanding it before you close is considerably cheaper than understanding it in April.

What is boot in a 1031 exchange?

Boot is value you walk away with that did not go into replacement property. It comes in two forms and most people only know about the first.

Cash boot is leftover money. You sold for 1.4 million, you bought for 1.2 million, and the 200,000 dollar difference landed in your account. That difference is taxable.

Mortgage boot, also called debt relief, is subtler and catches more people. You sold a property carrying a 500,000 dollar mortgage and bought one with a 300,000 dollar mortgage. You received no cash at all, but you were relieved of 200,000 dollars of debt, and the IRS treats that relief as value received. It is taxed the same way the cash would have been.

The rule underneath both is straightforward. To defer everything, you generally have to buy replacement property of equal or greater value, reinvest all of the net proceeds, and replace all of the debt. Fall short on any of the three and the shortfall is boot.

How is boot taxed?

Here is the part that makes boot more expensive than people expect. Boot does not get a friendly rate.

It generally comes out against your unrecaptured depreciation first, which is taxed at up to 25 percent, before any long term capital gains rate applies. Most owners assume leftover cash would be taxed at 15 or 20 percent. On a long held rental where depreciation has accumulated for two decades, the first slice of boot is almost always recapture.

A 200,000 dollar remainder on a property with substantial accumulated depreciation can therefore cost around 50,000 dollars federally before your state takes anything. On top of that the boot counts toward income for the year, which can push you across the 3.8 percent net investment income tax threshold you were previously under.

One piece of good news. Boot is taxed only up to the amount of gain you actually realized. If your gain was 40,000 dollars and your boot was 60,000, you are taxed on 40,000.

Can cash and debt boot cancel each other out?

Partly, and the rule runs in one direction only, which is where people get caught.

Adding cash cures debt relief. If you took on less mortgage than you gave up, you can make up the difference by putting additional cash of your own into the purchase. The shortfall disappears.

Taking on debt does not cure cash received. If you pulled cash out at closing, borrowing more on the replacement property does not offset it. The cash is still taxable.

Practically, that means if you are going to end up short on one side, being short on debt is the fixable problem and taking cash out is not. Plan accordingly.

Where boot comes from when nobody meant it to

Most boot is accidental. It appears in places that look administrative.

• ›The settlement statement. Prorated rents, security deposits transferred to you, and repair credits from the seller can all land as cash in your pocket and therefore as boot.
• ›Non transaction costs paid from proceeds. Exchange funds used to pay things that are not closing costs of the sale, such as prepaid property tax or insurance on the new property, can be treated as boot.
• ›Buying slightly cheaper. The single most common cause. Nothing on the market is priced at exactly what you sold for, so a gap is normal rather than a mistake. It is only a mistake if you leave it there.
• ›Paying off a mortgage and buying with less leverage. Very common for owners deliberately trying to deleverage in retirement, who are surprised to find that reducing debt creates a tax bill.

How do you avoid boot entirely?

The discipline is not complicated, it just has to happen before closing rather than after.

• ›Buy up, not down. Replacement property of equal or greater value than what you sold, before selling costs.
• ›Reinvest all of the net proceeds. Every dollar that leaves the Qualified Intermediary's account for anything other than the purchase deserves a second look.
• ›Replace the debt, or add cash instead. Match the old mortgage with new financing, or bring outside money to fill the gap. Both work.
• ›Handle prorations outside the exchange. Pay for deposits, prorated rent and credits with personal funds rather than letting them come out of exchange proceeds.
• ›Use a precisely sized replacement for the remainder. This is where fractional structures earn their place. A Delaware Statutory Trust interest can be subscribed in an exact dollar amount, so an awkward 180,000 dollar remainder that no building will absorb can be placed rather than taxed. It is one of the most common practical uses of the structure.

Is a little boot ever acceptable?

Sometimes, and it is a legitimate decision rather than a failure.

If you need cash out of the transaction for a real reason, taking deliberate boot and paying the tax on it is a perfectly sensible plan. The problem is never boot you chose. It is boot you did not notice until your CPA pointed at it.

The distinction worth holding onto is this. A partial exchange is a strategy. An accidental partial exchange is an expensive surprise, and the difference between them is usually a conversation that happened two weeks before closing rather than two months after it.

Every figure here is illustrative and nothing in this article is tax, legal or investment advice. Rates, thresholds and rules change and depend on your circumstances. Work your own numbers through with your CPA before you act.