The term “boot” is not used in the IRS regulations, however, it is commonly used to describe the cash or proceeds that an investor receives in addition to the replacement property when completing a 1031 exchange. The IRS is very clear that receipt of cash or proceeds either during or at the conclusion of an exchange will trigger recognition of gain and, therefore, tax. Since tax deferral is the most compelling reason to complete a 1031 exchange, an investor needs to be very careful to avoid this very situation.
The easiest way to understand how to avoid boot in a 1031 exchange is to look at it as two requirements:
- You must purchase at least as much as you sell. This refers to the net selling price of the property after all closing costs and commissions have been paid.
- You must use all of the cash generated by the sale in the next purchase. This amount is the net cash after all costs of sale and satisfaction of mortgage have occurred.
Want a different perspective that will give you the same result? Take the amount of cash generated in the sale and add to that the amount of debt that was relieved in the sale and that is your reinvestment target.
It is possible to still do a 1031 exchange and purchase less than what you sold and/or take some cash proceeds out, but any difference will be taxed. So if you sell a piece of property for $200,000 and want to buy a property for only $150,000, your difference of $50,000 will be subject to taxes. If you purchased the property originally for $150,000, obviously you’re going to be paying tax on all of your gain so there is no compelling reason to do the 1031 exchange. If you paid $100,000 for the piece of property, then you would be paying the tax on the “gain” of $50,000 but still be sheltering the other $50,000 gain.
We are asked all the time about returning someone’s original capital. That initial investment would never be considered a gain. Unfortunately, while that is correct and the taxpayer may argue that they are only taking back their original capital – the IRS will say that the taxpayer is taking profit first. And since the IRS has bigger cannons, their interpretation is what counts.
There are a number of scenarios that can be used to generate the cash a taxpayer desires while still preserving the tax-deferred status of a 1031 exchange. However, it is critical when contemplating these strategies that the taxpayer consult with a competent experienced qualified intermediary and their tax professionals and legal counsel to ensure the best result. After all, no pirate sails alone into uncharted waters.
The materials available at this web site are for informational purposes only and not for the purpose of providing legal or tax advice. You should contact your attorney or tax advisor to obtain advice tailored to your circumstances.