A like-kind exchange, or a 1031 exchange, is an effective method for deferring capital gains taxes on a replacement property when swapping like-kind assets. This exchange occurs between real estate investors who trade properties that they hold as investments or use for business purposes. For instance, an apartment building can be swapped for an industrial building. In the United States, any like-kind property being exchanged must be traded with another property located within the country. However, opting to sell a property for a less expensive one may appear to be a simple means of decreasing debt and obtaining cash, but there is a drawback. If you obtain excess cash or decreased debt during a real estate exchange, it is taxable, and as a result, property investors may owe the IRS money unless they follow the necessary measures to avoid mortgage boot. Mortgage boot on a 1031 exchange can lead to significant capital gains tax costs for property investors. To delay these taxes, investors must replace the complete value of their original property.
Why Do I Owe Taxes on My 1031 Exchange?
Failing to replace the equity and debt of your relinquished property during a 1031 exchange will result in capital gains taxes on the 1031 mortgage boot. This boot can nullify your efforts to sidestep tax payments with the 1031 exchange, making it crucial to know how to avoid it. Any cash gains or debt reduction from a real estate exchange will incur tax payments as they are considered to be increased wealth, which qualifies as taxable income for taxpayers.
What Is a Mortgage Boot?
In real estate, the term “boot” refers to the extra money or property that an investor gains during an exchange, beyond what is necessary to complete the transaction. This profit or gain is based on the fair market value of the property being exchanged and is essentially an additional benefit for the investor.
The term “mortgage boot” refers to any extra value gained when the debt owed on a replacement property is less than that of the relinquished property in a real estate exchange. Essentially, if the value of the replacement property acquired is less than the property sold, the surplus amount received by the investor is called boot and is subject to taxation. For instance, if an investor has a mortgage of $120,000 on their relinquished property and acquires a replacement property with a mortgage of $110,000, then they will have $10,000 in mortgage boot.
How Did Boot Originate?
In real estate, the term “boot” originated from an English term that means “something given in addition to.” These additional gains can be obtained by property investors during a real estate exchange, such as receiving cash, obtaining debt relief, or adding personal property to a tax-deferred exchange. In essence, boot represents any extra benefit or profit that an investor acquires beyond what is required for the transaction.
The following sources can result in boot:
- Cash: Net cash flow is the money left over after a property investor sells one property and purchases another.
- Reduced debt: When property investors exchange their relinquished property for a less expensive property, they obtain a reduced debt amount. This implies that the amount they owe on the replacement property is less than the amount they previously owed on the relinquished property. Such an exchange is advantageous because it results in debt relief for the investor. However, the debt relief is taxable income, as it reduces the amount owed by the investor. It is worth noting that the debt on the replacement property must be at least equal to or more than the debt on the relinquished property.
- Sale proceeds: If a property investor uses the proceeds from selling their relinquished property to pay for non-closing expenses related to the relinquished or replacement property’s closing, it is considered equivalent to receiving cash. These non-closing costs can include prorations for rent, property taxes, tenant damage deposits, and any other expenses that are not part of the closing costs. However, the investor is not permitted to directly receive the money. Instead, the funds must be channeled through a Qualified Intermediary, failing which the exchange may be disqualified.
- Excess borrowing: Excess borrowing during a real estate exchange can lead to boot if an investor borrows more funds than required to purchase the replacement property. If the loan amount is excessive, the investor will be unable to use all of their exchange funds for the transaction, and any remaining funds will be subject to taxation. This is because the excess cash beyond the purchase price of the property counts as added value, which is taxable. Thus, it is crucial to be mindful of the loan amount to avoid incurring unnecessary taxes.
- Personal property: An investor can execute a tax-free exchange by selling a property for $500,000 and purchasing a $500,000 replacement property without acquiring boot. However, if the replacement property comes with any personal property, it is regarded as increased wealth because personal property is not considered as like-kind real estate. For instance, if a sale includes $100,000 worth of furniture or machinery, only $400,000 will be involved in the exchange, and the remaining $100,000 will be subject to taxation.
Mortgage Boot/Debt Reduction Boot Example
Consider that you own a property and sell it for $350,000 while still owing a remaining balance of $120,000 on your mortgage. Once the property is sold, you will use the sale proceeds to pay off the $120,000 debt to your mortgage lender. This will leave you with $230,000 from the sale of your relinquished property, which will be subject to closing costs.
To successfully carry out a 1031 exchange, the property investor is required to buy a new like-kind property whose value equals or exceeds the $230,000 remaining from the sale of the relinquished property after paying off the mortgage balance and any closing costs. If the investor purchases a replacement property for only $230,000, the $120,000 used to pay off the previous debt will be considered as capital gains and will be subject to taxation. This is because the debt reduction translates to additional value, which counts as increased income and is thus taxable.
How to Avoid Mortgage Boot Using the Debt Replacement Principle
To ensure a completely tax-free 1031 exchange, it is important to avoid receiving a boot by replacing the debt of your relinquished property. This can be achieved by replacing the debt when you complete your exchange. Examples of situations that would not result in a boot include the following:
- Trade Across or Up
To prevent a mortgage boot during a 1031 exchange, you can either trade across or trade up. This involves purchasing a replacement property with debt that is equal to or greater than the debt on your relinquished property. Regardless of the method chosen, it is crucial to reinvest the entire amount received from the sale of the relinquished property into the new property.
- Pay Extra on Your Replacement Property
A strategy to avoid paying capital gains taxes in a 1031 exchange is to make up for a lower replacement property mortgage by contributing additional funds. This approach is often taken by investors who anticipate an increase in market appreciation. However, since market values are unpredictable and may fluctuate, this method of debt replacement may not always be the most advantageous option.
- Purchase Two Replacement Properties
To prevent paying taxes because of a mortgage boot, you can opt to purchase two replacement properties with a loan amount that is equal to or higher than the value of your relinquished property. This strategy can make it easier to obtain a loan that fulfills the 1031 exchange requirements. While purchasing two properties may result in higher upfront costs, it may prove to be a profitable investment over time.
- Refinance
When it comes to refinancing a replacement property in the context of a 1031 exchange, it’s generally less risky to do so after the exchange. Refinancing before the exchange means you’ll take cash out, which could result in having less cash on hand, more debt on your replacement property, and debt paid off on your relinquished property after the exchange. However, if you have business purposes for the refinance that are independent of the anticipated exchange, the IRS may not challenge the exchange.
A pre-exchange refinance can be deemed acceptable by the IRS if it is carried out for legitimate business reasons, such as addressing cash-flow issues or repairing damaged buildings. However, if there are no such reasons, the IRS may view the refinancing as an attempt to withdraw cash and could tax it accordingly or deem the exchange abusive. On the other hand, post-exchange refinancing is generally accepted by the IRS as investors are required to repay the outstanding debt of their replacement property, resulting in no increase in wealth or gain to the taxpayer.
Another Example of How to Avoid a Mortgage Boot
To ensure that you do not incur mortgage boot taxes during a 1031 exchange, it is crucial to replace the debt value of your relinquished property. For instance, if you sell a vacation condominium for $900,000, you must consider both the equity and debt associated with the property. Assuming you have a $500,000 loan and $400,000 equity, you must allocate your $400,000 equity towards the purchase of your replacement property and replace the $500,000 debt from the previous property to avoid any tax liabilities.
There are several ways to replace the debt value of your relinquished property and avoid mortgage boot. The easiest method is to purchase a new property with a value of $900,000, equal to the value of your relinquished property. However, if your replacement property costs less, you will need to consider alternative options to replace your relinquished property’s value. Suppose your replacement property is valued at $800,000, leaving you with a potential $100,000 boot. In that case, you could consider providing additional funds to make up for the $100,000 shortfall.
You could also buy a replacement property that is more expensive than the one you gave up, or you could buy two properties, as long as the debt is equal to or greater than the previous debt. You could, for example, buy a $950,000 vacation condo or two smaller condos for $500,000 each.
1031 Exchange Rules
The 1031 exchange process is subject to a time limit set by the IRS. Investors must purchase their replacement property within 180 days of starting the exchange and identify potential replacement properties within the initial 45-day period, which is included in the overall 180-day period. Therefore, it’s crucial to use this time wisely to research and find a suitable replacement property that satisfies the required criteria. This highlights the importance of having a comprehensive plan in place before beginning a 1031 exchange.
For a successful exchange, investors must remember the following rules:
- Identify the replacement property on time: To comply with IRS regulations, investors must provide written descriptions of their potential replacement properties by midnight on the 45th day of the exchange process. These descriptions must include the exact address and unit numbers of the properties. This is crucial to verify that the replacement property aligns with the relinquished property and fulfills all relevant criteria set forth by the IRS.
- Follow the three-property rule and the 200% rule: As part of the 1031 exchange process, investors are allowed to submit written descriptions of up to three potential replacement properties. This is referred to as the three-property rule and is only applicable if the investor plans to purchase at least one of the identified properties. However, if an investor wishes to submit descriptions for more than three properties, they must adhere to the 200% rule. This means that the combined value of all potential replacement properties must not exceed 200% of the market value of the relinquished property.
- Know the rule exceptions: There are certain exceptions to the three-property and 200% rules. In case the selected replacement properties do not meet the criteria set by these rules, the investor must obtain 95% of the combined market value of their new holdings.
- Leave room to change your mind: Submitting your potential replacement properties early in the 1031 exchange process can be beneficial. This allows you more time to make changes if you decide on a different property. You can submit a new property in writing within the 45-day time limit if you change your mind. The earlier you submit your initial property descriptions, the more time you have to make changes and ensure that you meet the necessary criteria.
We at Investment.org connect you with the best-in-class financial and investment advisors who analyze your goals based on your risk appetite and help you meet them. Our advisors work closely with you and provide the latest 1031 exchange property lists. This list lets you identify the right replacement property in less than three days.
Sign up to our portal today to access the free 1031 property list or talk to our advisors.
