The market is starting to loosen up for investors seeking to sell their properties via §1031 tax deferred exchange. Once under contract investors need to understand a few specific items that may cause either a unintended tax issue or an issue with an expense taken at closing that is not permitted in a §1031 exchange.
March 4, 2025
By Al DiNicola, AIF®
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC, Member of FINRA/SIPC
Recently we have received calls from investors seeking information on what cash they can retain, what happens when the loan is paid off, and how rental and security deposits are handle at closing. We do not provide tax advice.
Let’s handle one item at a time. There is an item referenced as boot in an exchange. “Boot” refers to any portion of a §1031 exchange that does not meet the like-kind replacement property criteria. Most commonly this is in the form of “cash boot” and “mortgage/debt boot.”
Cash boot occurs when an investor has uninvested proceeds from the sale of a replacement property. If they intend to do a §1031 exchange but do not replace all of the cash received from the sale, they will owe tax on the uninvested portion.
Example:
If an investor sells an investment property for $2,000,000 and they purchase a replacement property for $1,500,000, they will have a $500,000 cash boot that will be subject to tax. The investor would be subject to federal and state taxes depending on where they live.
It has been brought to our attention in a few investment seminars that certain investors will over paid for their replacement property. This occurs when calculating the potential taxes that may be due on not using all the cash, when compared to simply paying more for the property (aka the asking price or even higher). If you are paying capital gains taxes, have a high income that may subject you to NIIT (net investment income tax), and live in a high income tax state you may face up to 40% taxes on the boot. Other investors (accredited) may determine they would rather negotiate a better price on the replacement property (meaning not using all the cash proceeds in the exchange) and then utilize a Delaware Statutory Trust (DST) for any remaining cash boot. DSTs are scalable and can handle left over cash from the exchange.
Mortgage/debt boot occurs when the mortgage value on the replacement property is less than the mortgage on the relinquished property. It is important to consider this when doing a §1031 exchange as both the cash received AND the debt need to be replaced in the acquired property.
Example:
An investor sells an investment property with a $500,000 mortgage and purchases a replacement property utilizing a $400,000 mortgage. This investor will be subject to tax on a mortgage boot in the amount of $100,000. It is important to note that this boot can be offset by adding $100,000 of cash to the exchange.
The easiest way to avoid a “boot” issue is to remember that you are replacing the total real estate value in a §1031 exchange. Both the equity and debt from the relinquished property need to be equal or greater in the replacement property.
There are reasons why an investor may have troubles with the replacement loan. In the short 45-day identification window the investor may need to qualify for a loan. Granted, there is a total of 180 days to close but most investors may wish to guarantee there is loan approval prior to identifying the replacement property. Accredited investors may seek to utilize Delaware Statutory Trust (DSTs) as a replacement property. DSTs provide non-recourse debt pre package for investors without application or effects on individual credit reports.
When we work with an accredited investor we take into consideration suitability of replacement assets as well as balancing the utilization of cash and the inclusion of replacement debt if necessary.
NAMCOA® is a SEC registered investment advisory firm that provides comprehensive portfolio management, financial planning, and fiduciary decision-making services on behalf of retirement plan sponsors. Our Difference is summarized by our fiduciary approach which enables us to better meet portfolio and retirement plan objectives, resulting in stronger risk adjusted returns for investors and peace of mind for Clients. We also focus on alternative real estate investment. Many real estate investors are seeking tax deferred solutions utilizing §1031 exchanges or Opportunity Zones.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 5 Centerpointe Drive, Ste. 400 Lake Oswego, OR, 97035 MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
Thank you.