For real estate investors, 1031 exchanges have become a steadfast way to maximize profits and limit their capital gains tax liability. It’s not hard to see the appeal as deferring capital gains taxes on the sale of an investment property increases the investor’s purchasing power.
However, 1031 exchanges are complex beasts that the IRS heavily regulates. One key factor to be aware of is what is referred to by some as a “non-like-kind exchange boot.” In this article, we’ll discuss boot in 1031 exchanges and what investors interested in a 1031 exchange need to be aware of.
What is a Non-Like-Kind Exchange Boot?
A critical stipulation for a 1031 exchange involves the replacement property being of a “like-kind,” which means it should be similar in nature and character. Any element in the exchange that doesn’t meet this “like-kind” criteria is categorized as a boot.
I.E., any portion of proceeds you receive during a 1031 exchange not reinvesting into the replacement property or related real assets may be considered “non-like-kind exchange boot.” Typically, boot come in the form of cash or installment notes but can come in many forms, such as mortgage reductions.
However, it’s also worth noting that boots can be re-invested into additional like-kind properties to potentially avoid tax liability.
Let’s break it down. Here’s how boot works in a 1031 exchange:
This is important because the boot from a 1031 exchange is not exempt from capital gains taxes and will be considered taxable income.
Even though non-like-kind exchange boot often comes in the form of cash, they also come in other forms, such as:
- Direct Cash Payments: This is the most straightforward example of boot. If you receive extra cash from the purchaser of a relinquished property, it is considered boot.
- Excess Proceeds: If sales proceeds from the relinquished property exceed the cost of the replacement property, the extra amount will be considered boot.
- Mortgage Relief: If the mortgage on the replacement property is less than the mortgage on the relinquished property, the difference can be considered as mortgage relief boot. Even though it doesn’t come in cash, it is taxable.
- Netting Out Liabilities: If the liabilities assumed by the buyer of the relinquished property are less than those assumed on the replacement property, the difference will be considered a boot. This is often referred to as a “net boot.”
- Personal Property Boot: When you swap real property, such as a multifamily building, for personal property, the divergence in fair market values between the real estate and the personal assets is categorized as boot.
- Non-Qualified Property: If you receive non-qualified properties such as stocks, bonds, promissory notes, or appliances as part of a 1031 exchange, the value of these assets could be considered taxable.
- Closing Costs: Additional costs associated with closing on the replacement property, such as mortgage insurance costs incurred to secure a mortgage, may also be considered boot.
Why it Matters
Regarding 1031 exchanges, investors aim to optimize their profits and minimize their capital gains tax liability by deferring as many taxes as possible. When investors incur “non-like-kind exchange boot,” they add at least some tax liability exposure to the transaction.
Investors need to be aware of boot in 1031 exchanges because doing so is imperative to keeping track of the tax implications of these large transactions. Failure to do so could result in penalties or issues with the exchange process. Here are some things to consider:
- Identification and Reporting: It’s crucial to carefully identify and report any boot involved in the exchange, regardless of the boot type.
- Taxable Gains: Any boot received will most likely be taxable.
- Basis Adjustments: The basis of the property you acquired during a 1031 exchange is adjusted to account for any boot received. This could potentially alter future depreciation deductions and capital gains when you do sell the replacement property.
- Timeline Considerations: 1031 exchanges occur within stringent timelines such as the 45-day identification period and the overarching 180-day exchange period. Taking the time necessary to calculate and account for boot adds extra work, making these timelines more challenging to navigate, so be sure to plan accordingly.
- Keep Accurate Records: Maintaining detailed records for reporting is a crucial part of the post-exchange period. You should note the exchange record, the fair market values of all properties involved, the boot received, and any other relevant documentation. Accurate records are essential for compliance with tax law.
As you can see, boot can come in various forms and can substantially impact investors’ tax obligations in a 1031 exchange. Their presence introduces added intricacy to an already complex process, necessitating vigilant planning within the confines of the tight 1031 exchange timelines.
Also, because 1031 exchanges are so complex and failure to adhere to strict rules and regulations can result in a voided exchange, always consult a tax professional or financial advisor.
Suppose you’re an investor looking to lessen the pressure of a 1031 exchange or sell an investment property without managing your replacement property. In that case, Canyon View Capital may be able to help.
Canyon View Capital Helps Ease the 1031 Exchange Process
The Canyon View Capital team is passionate about multifamily real estate. It’s at the core of everything we do and part of why we now manage a multifamily portfolio valued at over $1 billion. We want to leverage our experience to help investors like you realize the benefits of passive multifamily investing.
We simplify 1031 exchanges by offering multifamily properties as tenants in common. This option streamlines the exchange process and facilitates reinvestment of “like-kind exchange boot,” allowing investors to defer capital gains taxes and enjoy passive multifamily income without property management hassle.
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12$1B figure based on aggregate value of all CVC-managed real estate investments valued as of March 31, 2023.
Gary Rauscher, President
When Gary joined CVC in 2007, he brought more than a decade of in-depth accounting and tax experience, first as a CPA, and later as the CFO for a venture capital fund. As President, Gary manages all property refinances, acquisitions, and dispositions. He works directly with banks, brokers, attorneys, and lenders to ensure a successful close for each CVC property. His knowledge of our funds’ complexity makes him a respected executive sounding board and an invaluable financial advisor.