The U.S. tax code section 1031 provides an opportunity to swap like-kind real property and escape the tax or pay very little tax in the process. While most real property exchanges and sales incur taxes, those transactions that meet the criteria of section 1031 are exempted.
However, if one fails to meet the “like-kind” swap criterion and find themselves with leftover cash from the transaction, that is what is called the boot. Thus, the boot is to be avoided if possible.
What are Common Sources of Boot?
To take advantage of section 1031, the property involved must be real property and must be for business or investment; not personal.
While a primary home does not apply, vacation homes do qualify for the 1031 swap though you should consult with a lawyer regarding such a swap as there are very specific rules involved. Common situations that result in a boot are as follows:
- Cash gained in an exchange. If you sell a higher valued property for a lower valued property, than the cash received for the difference is the boot.
- Excess money borrowed. If you borrow more than required to purchase the new property, the excess money is taxable unless you make arrangements to invest it in the “like-kind” property.
- Money from the sale of property used to pay for non-qualified expenses outside of regular closing expenses may be considered boot.
- Debt reduction gains. If your transaction results in a debt reduction than that capital gain is taxable.
- Trading a property for another that is not “like-kind” under the criteria proscribed by 1031 will cause a boot.
How Can I Avoid Receiving Boot?
The easiest method for avoiding boot is to not trade-down. Providing cash for any unqualified expenses at closing will also prevent the possibility of boot. Using a qualified intermediary can help diversify your options.
Section 1031 allows for a delay in the swap as long as the money is held by a qualified intermediary before you can purchase or close on the new “like-kind” property.
Additionally, “like-kind” is liberally defined so there may be a lot of investment or business opportunities available to choose from. Utilizing the rules found within 1031 can help create such opportunities.
Do I Need a Lawyer to Help with a Boot Problem?
Real estate lawyers and tax lawyers that specialize in such areas can greatly increase your options for reinvestment as well as advise you regarding any possible boot and how to reduce your tax liability in the exchange. It is better to discuss these issues with a local real estate attorney before you make the trade so that you can prevent unnecessary taxation.