Taxation of Boot in 1031 Exchanges
In an ideal situation, a Sec. 1031 like kind exchange involves a total of two parties and both parties defer substantial gain. This is an ideal scenario for several reasons. First, there’s no need to procure the services of a 1031 facilitator or “qualified intermediary”. No facilitator is required in a two party direct swap exchange. Another reason is that there’s less likelihood of any boot being recognized by either party. In a 1031 exchange, “boot” refers to property received which is not “like-kind” to the property relinquished.
Boot can take various forms. The two most common forms are cash boot and mortgage boot. In a direct swap exchange involving only two parties, boot is less common. That’s because the properties in such exchanges are typically owned free and clear (no mortgage boot) and often don’t include cash on top of the transaction. Boot in 1031 exchanges is an important topic. It’s also the focus of this blog post.
The Rarity of the Direct Swap
In reality, direct swap exchanges are now the least common type of 1031 exchange in the commercial world. It’s relatively rare for an investor to locate another investor for a tax advantaged deal. It’s even harder to find two that both desire what the first investor has and has what that investor desires. More commonly, an investor first locates a buyer for his or her investment. Later, they locate a seller. That’s, sometimes, referred to as a “delayed exchange”.
The most common variation of a 1031 exchange performed today is, in fact, the delayed exchange. It requires the involvement of a qualified intermediary, though. In these transactions, it is quite common for the investor to recognize some amount of boot. In this post, we will discuss the basics of boot taxation. We’ll also look at how boot affects basis transfer in the replacement property received in a 1031 exchange.
Basics of Boot
Whenever an investor receives any property in an exchange which is not of a like-kind to the property relinquished, this is considered “boot” and will constitute a taxable event. Boot can take different forms. The most common forms of boot are cash boot and mortgage boot (or “debt relief”). When Sec. 1031 transactions were in their infancy, the IRS argued that the receipt of boot invalidates the exchange. Their reasoning was that this receipt goes against the underlying exchange concept. The IRS made the same argument regarding exchanges which involved contingencies which could potentially result in sales. In both cases, the courts ruled that neither boot nor contingencies invalidate the exchange, provided that an actual property transfer occurred.
Example #1: Boot in 1031 Exchanges
Today, boot in 1031 Exchanges is very commonly recognized by investors. Sometimes that’s by by choice. Other times, it’s due to an inability to locate replacement property which is of sufficient value. Here’s a simple boot scenario. An investors sells a property with a basis of $500,000 and a sales price of $750,000. The investor wishes to utilize a portion of the sales proceeds for an outside venture. Accordingly, the investor deliberately chooses to take $100,000 in cash boot from the exchange funds. The other $650,000 is used for the replacement property. This $100,000 would be taxable to the extent of the investor’s gain. In this case, that’s $250,000, so the entire sum would be subject to tax.
Let’s look at another example. Suppose an investors sells a property with a basis of $250,000. It’s subject to a mortgage of $250,000 and has a sales price of $700,000. The investor receives exchange proceeds of $450,000 after paying off the preexisting mortgage. She then acquires a replacement property which has a sales price of $550,000. The investor obtains a new mortgage on the replacement property of $100,000. In this scenario, the investor will have mortgage boot in the amount of $150,000, and this entire sum would be subject to tax because the investor had a gain on the relinquished property of $450,000.
Investors commonly misunderstand the taxation of boot in 1031 exchanges. Many investors think that boot will reduce their basis in the replacement property they receive. They don’t realize, though, that it’ll be taxable upon receipt. In fact, any time an investor receives boot in an exchange, the boot will be taxable to the extent of the gain. There can never be a situation in which an investor receives boot and does not face a taxable event. If an investor manages to utilize Section 121 on a property which is converted to an investment property and then later used in an exchange, then the investor may receive tax free cash, but this is only because Section 121 eliminates a portion of the gain.
Different States, Different Results
Boot will taxed at the federal level and potentially at the state level depending on the investor’s location. Some states, though, do not currently have a state personal income tax. In those states, boot would not trigger a taxable consequence at the state level. Whenever an investor receives boot, he or she should always consult with a qualified accountant in order to put themselves in the best financial situation.
Experienced New York Tax Attorneys
We’ve previously seen in our posts on Section 1031 exchanges that like kind transactions can be complicated. It’s imperative, therefore, that investors hire qualified professionals to help guide them through the process. Hiring the wrong person to handle your exchange can potentially lead to a failed exchange and severe financial penalties. If you have questions regarding Section 1031 or any other tax matter, feel free to reach out to one of the top New York City tax attorneys at our firm and we will be happy to counsel you. The tax lawyers at Mackay, Caswell & Callahan, P.C., have expertise in a wide range of areas. With New York offices in several cities including Albany, New York City, Rochester and Syracuse, a New York tax attorney is available to help you. Give us a call; we have an established track record of bringing value to the clients we serve.
Image credit: TaxRebate.org.uk