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.