The U.S. tax code section 1031 provides opportunities to swap like-kind real property and escape taxes or pay very little tax in the process. While most real property exchanges and sales incur taxes, transactions that meet the criteria of section 1031 are exempted.

However, if one fails to meet the “like-kind” swap criterion and finds themselves with leftover cash from the transaction, that is the boot. It is best to avoid the boot if possible.

What are Common Sources of Boot?

To take advantage of section 1031, the property involved must be real property for business or investment, not personal use.

While primary homes do not apply, vacation homes qualify for the 1031 swap. You should consult with a lawyer regarding such a swap as very specific rules are involved. Common situations that result in a boot are as follows:

  • Cash gained in exchange: If you sell a higher valued property for a lower valued property, 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 reduces debt, that capital gain is taxable.
  • Trading property for another not “like-kind” under the criteria proscribed by 1031 will cause a boot.

How Can I Avoid Receiving Boot?

The easiest way to avoid boot is to not trade-down. Providing cash for any unqualified expenses at closing will also prevent the possibility of the boot. Using a qualified intermediary can help diversify your options.

Section 1031 allows for a delay in the swap as long as a qualified intermediary holds the money before you can purchase or close on the new “like-kind” property.

“Like-kind” is liberally defined, so there may be many investment or business opportunities available to choose from. Utilizing the rules found within 1031 can help create such opportunities.

What Are the Types of Boot in Real Estate?

Boot can result in several ways from a real estate investment exchange. Below are the most common types of boot in real estate:

  • Mortgage or Debt Reduction Boot: Mortgage boot or debt reduction boot may occur when the replacement property’s owed debt is less than the debt owed on your relinquished property. Reducing your debt liability is considered income because it is cash that you once owed that will now remain in your pocket at the tie the debt matures. Income is taxable. If your replacement property’s mortgage is $50,000 and your relinquished property’s mortgage is $70,000, you will have $20,000 in debt reduction boot, even if you use all your sales proceeds to buy the replacement property.
  • Cash Boot: Cash boot occurs in several ways. You can acquire cash boot by having net cash received amount. When the cash received from the relinquished properties sale is greater than the cash paid to purchase the replacement property, you will have a net cash received amount that is considered taxable income.
    • You can also accumulate cash boot by incorporating a promissory note into the exchange. Cash boot includes the use of interest earned on the sale proceeds while they were held before being used to acquire the replacement property. The seller of the replacement may pay for repairs that the buyer requires. The value of these repairs will be considered cash boot.
  • Sales Proceeds: Sale proceeds can result as boot if they are used to pay non-qualified expenses, such as service costs at closing that are not considered closing costs. At the closing, if you use your sales proceeds for non-transaction, the outcome is the same as if you received cash due to the exchange and used the cash to cover the costs. These services could include deposits for tenant damage transferred to a buyer, utility escrow charges, or rent proportions. To avoid turning your sale proceeds into boot, pay for such items using cash.

What is Excess Borrowing?

Excess borrowing can result as boot if you borrow more money than you need to purchase a replacement property. If the loan is too large, you will not be able to use all of your exchange funds to purchase the replacement property. You will be taxed on any remaining funds.

For example, if your replacement property and relinquished property each have a market value of $200,000, but the relinquished property has an $80,000 debt, and your mortgage on the replacement property is $200,000, you’ll have a taxable cash boot of $120,000 returned to you at the closing of the 1031 exchange because you financed your replacement property in excess.

What is Non-Like Kind or Personal Property Boot?

Non-like kind or personal property boot occurs when a replacement property’s purchase includes personal property or non-like kind items. Non-like kind or personal property is less common, but it is important to know that the following items are considered personal property rather than like-kind:

  • Appliances
  • Farm sprinkler equipment
  • Fixtures
  • Furniture

If a replacement property purchase includes personal items, the value of the like-kind property alone is less than the purchase price for the like-kind property in addition to the personal property items.

You will be taxed on the value of the personal property items obtained alongside the replacement property if the like-kind property alone is not of greater or equal value than the value of the relinquished property. The easiest way to avoid personal property boot is to state in the selling contract that the listed personal property items are not included in the sale.

You can purchase the items separately with a separate sale agreement using cash out of your pocket rather than the cash you receive from the relinquished property’s sale.

What is Personal Residence Boot?

A personal residence boot is a less common form of boot that occurs when you use a part of a replacement property as a personal residence. If you purchase a property with multiple units, you may not reside in one of them without being taxed on the value of the portion of the property you choose to reside in if the value of the remainder of the property is not greater than or equal to the value of the relinquished property.

Be sure to discuss all items included in the sale of your relinquished property and the acquisition of your replacement property with an experienced real estate or tax lawyer. A real estate or tax lawyer should be your source to help ensure you do not accumulate this form of boot, whether intentionally or inadvertently.

What is an Offsetting Boot?

Boot received can be offset by a boot paid. Only your net boot is taxable. Even if you encounter a boot in your transaction, you can offset it and continue your tax-deferred transaction.

Do I Need a Lawyer to Help with a Boot Problem?

Real estate lawyers and tax lawyers specializing in such areas can greatly increase your options for reinvestment and 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 property attorney before you trade to prevent unnecessary taxation.