When faced with selling an investment property besides the amount of proceeds to pick up at closing the investor may consider the taxes that may be due. Investors may utilize a tax deferred 1031 exchange for all or part of the transaction.
By Al DiNicola, AIF®, CEPA ™
February 17, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
Tax deferred 1031 Exchanges and Boot
When faced with selling an investment property besides the amount of proceeds to pick up at closing the investor may consider the taxes that may be due. Investors may utilize a tax deferred 1031 exchange for all or part of the transaction. If you take proceeds off the table, the proceeds are referenced as boot. In addition, if you are doing an exchange and do not replace the loan that was paid off (either with another loan or fresh cash) you will be liable for mortgage boot. Understanding your overall tax liability should be a starting point.
The Internal Revenue Code does not formally use the term “Boot”. It is used in discussing the tax implications of a 1031 Exchange. In searching for a potential meaning here is a reference. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange.
Many consultants and investors agree that when done properly a 1031 exchange can provide a host of benefits to the investor today and in building an investment portfolio. The major benefits would be the deferral of capital gains as well as the deferral of recapture of depreciation.
There are situations where an investor believes they are executing a 1031 exchange but may fall short for a few reasons and end up owing money to the IRS.
When do you create Boot.
You acquired your relinquished property for $400,000 and sell your relinquished property for $1,000,000. (For this example we will not attempt to account for any commission or cost of sale). If the replacement property is $800,000 and you collect a check for $200,000 that would be considered boot and taxes would be due. This is income and would be taxed at the taxpayer capital gain rates. It is extremely advisable to contact your CPA. It may become more involved in determining your exact tax responsibility based on other factors such as recapture of depreciation taken under what maybe referenced as a partial exchange.
There is also another situation where mortgage boot may be present.
You acquired your relinquished property for $400,000 and sell your relinquished property for $1,000,000. There is a balance of $200,000 on the relinquished property. (For this example we will not attempt to account for any commission or cost of sale). Once the mortgage is satisfied you have $800,000 in cash. If the replacement property is $800,000 and you pay cash for the property without a loan the $200,000 loan that was paid off would be subjected to what is known as mortgage boot (debt reduction) and taxes would be due. Again, it is extremely advisable to contact your CPA. There is another consideration on this example which we will cover later in this article under Delaware Statutory Trust reference.
IRS rules for 1031 tax deferred exchange compliance are straightforward. Boot would be created in several scenarios. There are basically three main IRS rules or stipulation on being eligible or complying with the 1031 rules. That compliance would enable the exchanger to fully defer capital gains taxes.
The basic rules are:
- The replacement property needs to meet or exceed the market value of the relinquished property.
- The investor must use all the proceeds from the relinquished property to purchase the replacement property.
- If there is a debt satisfied (mortgage) upon closing, then the same amount of debt must be replaced, or the investor can substitute additional cash into the exchange.
Utilizing the rules from above.
- Meet or exceed market value. IF you are selling a property for $1,000,000 you must purchase a property for $1,000,000. There would be an offset for closing cost, commission and a few other items that would reduce the replacement price of the property.
- Use all the proceeds. If you receive $1,000,000 in proceeds all the proceeds need to be used.
- Replace debt. IF you are selling for $1,000,000 and have a loan paid off of $200,000 you need to have $200,000 in debt on the replacement property and use the additional $800,000 in proceeds towards the replacement purchase.
Exchange guidance may be available from the Qualified Intermediary (QI). Many Qis assist investors with the required forms and adherence to the dates mandated for identification of the replacement properties. In addition the QI may also be able to provide some guidance on balancing the exchange if they understand the terms of the purchase. Technically this may fall outside their scope of services. When an investors submits the replacement list to the QI the entire market value for the replacement property is stated with out the breakout of cash (equity) invested and the debt component making up the full value. CPAs and Financial advisors who deal with 1031 exchanges on a regular basis may be better suited for balancing the exchange.
There will be Boot can I still exchange?
If you did not satisfy all the requirements for the IRS for a full deferral you can still enter into and execute an exchange. The 1031 tax deferred exchange is not an all or none strategy. Partial exchanges are possible.
Delaware Statutory Trust (DST) may assist with mortgage boot issues.
There are times in an investors life when they simply don’t want to apply for, sign for, or be financially responsible for another loan on the replacement property. Recently we assisted an investor with and interesting challenge. The exchange was rather large and started with the sale of an apartment property. The sale was for $6.1 million but conceptually can be utilized in a lot of situations. Upon the closing of the relinquished property the investor retained $300,000 to pay for personal items. This would be recognized as boot and taxes due. Taking boot occasionally serves a purpose especially when there are other financial needs. There was a loan paid off on the property of over $2M. The investor wanted an additional cash extracted from the exchange in the amount of $400,000. This created an issue with balancing the remaining cash and satisfying the replacement of debt. The solution was to create a diversified portfolio of DSTs with Non-recourse debt to the investor that balanced the total exchange. The investor was seeking a solution that would avoid signing for any debt responsibility. DST are all structured with non-recourse debt. The balancing exercise blended DSTs with a variety of loan to value property enabling the investors to avoid any potential taxes on mortgage boot. There would be taxes on the cash taken out of the transaction. In addition, we also balance the overall replacement market price of the relinquished property. One helpful addition to the solution was the investor’s CPA who we engaged with early on to fully understand the investor situation.
We welcome calls from investors and CPAs on the 1031 exchange process as well as how DSTs may simply the exchange process. If you are in the midst of selling your property and looking for a few suggestions, please contact us.
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 firstname.lastname@example.org.
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