Boot is “non-like-kind” property received in an exchange. It can include: Cash, Liability, and Other Property
Cash Boot
Cash Boot occurs when equity, cash or any cash equivalent received as part of the sale of the relinquished property is not replaced fully in the replacement property. In some instances, Exchangers will receive equity at the closing of their relinquished property as part of their overall strategy; the portion received is subject to taxation and is considered Taxable Boot. For example, if you sold your investment property for $500,000 and paid off the $250,000 mortgage, after closing costs you would determine your net sales proceeds. Let’s say that the net sales proceeds for this sale are $200,000. The Exchanger is welcome to receive any portion of those funds at closing, but by receiving them will trigger a taxable consequence. Keep in mind that the more funds received reduces the benefit of the 1031 exchange and could potentially render the 1031 exchange useless.
Inadvertent Boot (Closing Costs & Non-Allowable Expenses)
When doing an exchange, settlement statement costs to the seller (you) will reduce exchange proceeds. In addition, the IRS treats Non-Allowable Exchange Expenses charged (debited) to the seller as taxable items, known as “Taxable Boot”. Some of the more common non-allowable exchange expenses include prorated rents, security deposit transfers, and loan fees. For example, a relinquished property is a rental building with an existing tenant, and the contract stipulates that the seller transfer the security deposit to the new owner. In this situation, the IRS does not consider the security deposit a closing cost; it simply is an additional business item that happens to be associated with the sales contract. However, if the settlement statement charges the security deposit amount against the seller, the debit reduces the exchange proceeds amount. The same rules are applied when the exchanger goes to purchase Replacement Property. The exchanger (taxpayer) would delineate any taxable boot reductions on their 8824 exchange reporting form, which requires them to pay taxes on the amount. As this example demonstrates, exchangers should strive to minimize Non-Allowable Exchange Expenses (Boot) during 1031 exchange closings on both the relinquished property and replacement property.
Mortgage or Debt Reduction Boot
This occurs when an exchangers debt (liability) on replacement property is less than the debt which was relieved on the relinquished property. Example: If the loan on the original property was $1,000,000 and the loan on the acquired property is $900,000, there is $100,000 worth of mortgage boot, which may be taxable. You may offset mortgage or debt reduction boot with cash, but you cannot offset cash boot with additional mortgage. In the above example, the Exchanger can add $100,000 of cash to offset the mortgage boot. However, if the Exchanger has $1,000,000 worth of net equity and trades into a building with only $900,000 of equity, the Exchanger receives $100,000 in cash and that cannot be offset with a larger loan.
Personal Property Boot
Personal property included in either the sale or purchase in an exchange will create taxable boot since it is classified as non-like-kind property. Only Real Property qualifies for tax deferral treatment under IRC Section 1031.
Example of an exchanger properly trading across in value including equity and mortgage:
As you can see the exchanger is trading up in value, across in equity, up in mortgage, and has avoided any non-allowable exchange expenses on both the relinquished and replacement property, therefore no taxable boot.