In tax terminology, boot refers to any property or cash received by the taxpayer that is not of a “like-kind” to the property being exchanged in an IRC 1031 exchange. This non-like-kind property can take various forms, including cash, relief of debt, personal property, or even services rendered as part of the exchange. While the primary objective of a 1031 exchange is to swap one investment property for another without triggering immediate tax consequences, the presence of boot can complicate matters.

Types of Boot:

Cash Boot: This is the most common form of boot and involves the receipt of cash or its equivalent as part of the exchange. For example, if the value of the replacement property is less than that of the relinquished property, the taxpayer may receive cash to balance the exchange.

Any cash received as boot in a 1031 exchange is subject to capital gains for the year of the exchange.  This tax is calculated based on the difference between the cash received and the adjusted basis of the relinquished property.

Mortgage Boot: In some cases, the taxpayer may assume a mortgage or other liabilities on the replacement property that are lower than those on the relinquished property. The difference between the two amounts represents mortgage boot. If the taxpayer assumes a mortgage on the replacement property that is less than the mortgage on the relinquished property, the difference constitutes mortgage boot.  This amount is treated as cash boot and is subject to capital gains tax.

Mortgage boot may also trigger depreciation recapture, requiring the taxpayer to recognize and pay taxes on any depreciation claimed on the relinquished property.

Personal Property Boot: Occasionally, personal property may be included as part of the exchange. If this property is not of a like-kind to real estate, it is considered personal property boot.  Similarly, compensation for service would be considered personal boot. Personal property boot received in a 1031 exchange is treated as ordinary income and is subject to taxation at the taxpayer’s ordinary income tax rate.

Boot Netting

Boot netting offers investors a strategy to manage the tax consequences associated with receiving boot. In a 1031 exchange, boot netting involves offsetting the boot received with any liabilities assumed as part of the exchange, thereby potentially reducing or eliminating the tax burden on the boot.

Here’s how boot netting works with a few examples:

Scenario 1:

Let’s say Investor A sells a property for $500,000 as part of a 1031 exchange. They plan to reinvest this money into another property to defer capital gains tax. However, as part of the exchange, they also receive $50,000 in cash, which is considered boot.

To minimize the tax impact of this boot, Investor A can use boot netting. They can identify other like-kind property expenses or liabilities associated with the exchange. For example:

  1. If they incur $30,000 in closing costs, these expenses can be used to offset the boot received.
  2. If there are outstanding mortgages or loans on the relinquished property amounting to $20,000, this debt can also offset the boot.

In this scenario, the total boot received is $50,000, but Investor A can offset it with $50,000 in expenses and liabilities associated with the exchange. As a result, they won’t owe capital gains tax on the boot because it has been effectively “netted out.”

Scenario 2:

Suppose Investor C sells a rental property for $900,000 and identifies a replacement property worth $850,000. This leaves $50,000 in potential mortgage boot. However, the buyer of the replacement property, Investor D, agrees to assume a mortgage on the relinquished property as part of the exchange.

  • Investor C transfers the mortgage on the relinquished property to Investor D, with a balance of $50,000.
  • Investor D assumes the mortgage obligation, effectively offsetting the potential mortgage boot.
  • The exchange is now balanced, with no net mortgage boot received by either party.
  • Both parties complete the exchange without any immediate tax consequences related to the mortgage boot.

In both examples, boot netting allows the parties involved in the 1031 exchange to balance out the boot received and given, minimizing tax consequences and facilitating the exchange of like-kind properties without the immediate tax burden. It’s crucial to ensure that such transactions comply with IRS regulations and are properly structured with the guidance of tax professionals.

Navigating boot in a 1031 exchange can be complex, with varying tax implications for different types of boot. Effective use of boot netting strategies can help mitigate potential tax liabilities. Always seek professional advice to ensure compliance and optimize your exchange benefits.

YSZAndrew

June 3, 2024

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