Boots are portions of 1031 exchanges that do not meet the tax-free criteria, and so are immediately taxed. Non-transaction costs can be booted along with cash proceeds and mortgage reductions. For optimal tax benefits and to avoid unnecessary liabilities, understanding the boot’s implications is essential, even though it won’t disqualify a 1031 exchange.
Types of boot in 1031 exchanges
A cash boot occurs when an investor does not reinvest all of the proceeds from the sale of a relinquished property into a new property. If an investor sells a property for $450,000 and invests only $400,000 in a replacement property, they are considered to have booted $50,000. Capital gains tax deferral is the primary reason most investors complete a 1031 exchange – to defer their capital gains taxes on the boot.
Mortgage boots occur when the mortgage on the replacement property is less than the mortgage on the relinquished property. Assume your relinquished property had a mortgage of $200,000, but when you acquired your replacement property through a 1031 exchange, its mortgage was $100,000. The debt reduction boot would be $100,000 in this scenario. The difference between the mortgage amounts creates a $100,000 taxable boot even if you use 100% of the sales proceeds from the relinquished property to purchase the replacement property.
Tax liability can result from non-exchange expenses, such as certain closing costs, in addition to exchange expenses. Likewise, non-qualified properties can be booted, i.e., properties that are not considered like-kind properties. In addition to stocks, bonds, partnerships, and personal property, other items can also be listed here.
Is there an unwanted boot avoidance or mitigation?
Some investors know that they will have to pay taxes on the proceeds of a sale; they prefer to use some of the proceeds for a life event. Investors should understand how to avoid or mitigate unwanted boot in their transactions due to the potential tax implications.
Consider these factors:
Reinvesting all proceeds. Cash boot can be avoided by investing all proceeds from the replacement property sale.
Retaining the value of replacement properties. An equal or greater value replacement property (or properties) must be purchased to prevent booting.
Incorporating mortgage balances. There may be a mortgage on the replacement property. Replacement property value is expected to be equal to or greater than relinquished property value.
Finding a qualified intermediary (QI). Ensure that all 1031 exchange rules and procedures are followed by working with a qualified intermediary.
In order to pay for non-closing costs, outside funds are used. Rent prorations and tenant deposits are not included in the exchange, so you will need to pay these expenses with funds not included in the exchange.
Separation of personal property. Whether personal property is included in the purchase price should be specified in the contract. It may be prudent to consider it as a separate transaction.
Additionally, the boot can have complex tax implications at the federal level. State taxes may also apply to investors in some states. The rate depends on the investor’s income tax bracket. In addition to their other income sources and expenses, an investor in the highest tax bracket (37%), receiving $50,000 in cash boot, might end up owing $18,500 in taxes.
DST investment option
It may be beneficial to invest the boot in a Delaware Statutory Trust (DST) if a boot appears unavoidable when exchanging real estate. It is a form of real estate investment that allows multiple investors to hold fractional interests in one property. The DST provides a way to reinvest the excess cash or boot from a 1031 exchange, thereby providing income and deferring taxes.
As an investment vehicle, you can also invest in higher-quality, institutional-grade properties without having to manage them independently, which is a great solution for those who wish to purchase high-value properties but are unable to afford or do not want to handle them on their own. DSTs are sometimes used by investors as a backup plan, avoiding the closing risk associated with other properties.
Additionally, DSTs generally have minimums as low as $25,000 to $100,000, providing an option for investors to invest down to the exact dollar amount, fulfilling their equal or greater requirements for a fully tax-deferred exchange.
Platforms like 1031 investment.org offer an extensive array of 1031 exchange DST opportunities, providing real estate investors with tools to maximize the exchange benefits and mitigate tax implications. Since DSTs carry their own requirements and restrictions, it’s important to consult with experienced professionals about the potential risks and benefits involved.
Ultimately, boot is an intricate topic that can significantly impact the tax benefits of a 1031 exchange, so knowing how to navigate it is vital. With strategic planning and a keen understanding of the tax landscape, investors can utilize 1031 exchanges to their full potential while minimizing or even eliminating the impact of boot.
