AVOIDING “BOOT” IN A 1031 Tax Deferred Exchange!

Al DiNicola DST Investments, LLC -Registered Investment Advisors

The word “boot” is an interesting word and one that may be hard to define. When you hear boot, you may feel like someone giving you the boot.  Actually, the reference to boot is the money (or other property) that is received or could be deemed to be received, but is not of a “like kind” to the relinquished property the real estate that is sold or the relinquished property (the real estate that is purchased) in the 1031 exchange.

Investors generally want to avoid boot, when conducting a 1031 tax deferred exchange transaction, so they can defer paying taxes (or in their mind avoid) on the value of the boot. It is always challenging to find a replacement property for the exact dollar amount of the relinquished property (resulting in boot which is taxable to the investor), it may be advantageous to identify more than one replacement property. An investor can identify up to three properties within the 45-day identification period to provide a tax deferral. Another strategy may be to utilize the 200% rule as well. Delaware statutory trust, or DSTs, may be helpful in avoiding boot. Below is an illustrative example using a replacement property and two DSTs.

EXAMPLE OF A SOLUTION TO AVOID BOOT

Sale Price of Relinquished Property:$1,000,000
Replacement Property #1 (Regular Real Estate)$800,000
Replacement Property #2 (DST property)$100,000
Replacement Property #3 (DST property)$100,000

Result: Investment into DSTs brought the value of all replacement properties to $1 Million, providing full capital gains deferral to the investor.  

In general, an investor that wants to defer (although some may reference avoid) paying taxes in a 1031 exchange transaction should look to purchase a “like Kind” replacement property with a value equal to or grater than the value of the relinquished property. Investors should also plan to reinvest all of the new sale proceeds from the sale of their relinquished property and make sure that either the debt on the replacement property is equal to or greater than the debt on the relinquished property, or, if the debt on the replacement property is less than the debt on the relinquished property, the investors funds the difference with their own cash. (DSTs also can provide the debt component with additional advantages).

Do’s and Don’ts of 1031 Tax Deferred Exchange

New Asset Value always must be=>Relinquished property
Cash invested in replacement property always MUST be=>Cash Received from Relinquished property sale
Debt on Replacement Property=>Value of debt from Relinquished property

“Boot” may arise in these common situations in a 1031 Exchange Transaction

  • Keeping some cash from the transaction. Cash sales proceeds received at the closing of the relinquished property in not reinvested into replacement property will be considered boot.
  • Sales proceeds used to pay non-closing expenses at closing.  If sales proceeds are used to pay cost at closing that are not the type of closing expenses that can be used to offset sales proceeds during a 1031 tax deferred exchange, then the result may be the same as if the investor received cash proceeds and used the cash proceeds to pay these cost. However, certain types of transaction and closing cost paid with cash proceeds off set cash boot received.
  • Debt Reduction. Debt reduction boot, also known as mortgage boot, occurs when the debt encumbering the replacement property whether assumed or placed on the replacement property as part of the purchase, is less than the debt paid off or assumed by the purchaser with respect to the sale of the relinquished property.  Debt reduction boot can occur when an investor is buying a replacement property that has an adjusted gross purchase price that is less than the adjusted gross sales price of the relinquished property.

Rules of offsetting Boot

  • Cash paid off sets cash boot received at the same closing table
  • Cash paid offset mortgage received
  • Mortgage boot paid offsets mortgage boot received.
  • But an excess mortgage amount placed on or assumed with respect to the replacement property does not offset cash boot received.

The rules regarding boot are complex and may vary with the facts and circumstances to each investor. This communication does not constitute tax advice for any investor. Potential investors must consult with their own tax advisor. For more information on how to properly set up an IRC 1031 Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098.

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