1031 exchange boot
is a taxable benefit received by the taxpayer in a 1031 exchange. Also known as like-kind exchanges, the capital gains deferral strategy is used by taxpayers of all means–resident and non-resident–who own property held for productive use in a trade, business or for investment and replace with like-kind property within 180 calendar days of the initial sale.
1031 Exchange
By entering into a 1031 exchange, the taxpayer can defer the federal, state and local capital gains and recaptured depreciation taxes given 100 percent of the net equity from the relinquished or old property sale and debt retired are replaced in the new property. If not, a tax is triggered on the cash received or debt not replaced.
For example, Scott is selling a rental property for $250,000 that has a $70,000 loan. The net equity or cash due Seller at closing is approximately $160,000 ($250,000 less selling and closing expenses of $20,000 less $70,000). He bought the property in Kentucky (6 percent state capital gain tax) for $175,000 ten years ago and depreciated it each year. He is married and their combined income places them in the 18.3 percent federal capital gain tax bracket. The estimated tax on the sale is $29,500. To defer the entire gain, a replacement property of $230,000 must be acquired. If the full proceeds or debt are not replaced then a tax is triggered on the difference in what is known as a partial exchange.
Equity Boot
There are two types of 1031 exchange boot: equity and mortgage boot. Equity boot is when the taxpayer initiates a 1031 exchange and receives cash at the sale of the relinquished or old property closing rather than wiring all net equity for use in the 1031 exchange. Cash can be received either at the beginning of the 1031 exchange, though this is taxable, or once the exchange is completed in a post exchange refinance where the cash received does not trigger a tax.
Earnest money deposit received before the relinquished property closing can be returned to escrow or the closing company without incurring a taxable event. If the cash is not returned at closing then a tax would be imposed and reported for the year the property was sold. Access to the earnest money deposit does not violate the constructive receipt rules of the Internal Revenue Code because at the time of receipt, a 1031 exchange has not been initiated.
Mortgage Boot
Mortgage boot represents debt not replaced in the replacement property. In Scott’s 1031 exchange above, if a property is acquired for $180,000 with no debt, then a $50,000 tax is assessed. The taxpayer has received the benefit of no longer having the debt. He did add $20,000 to the purchase that offset the same amount of debt. Additional cash always offsets debt, but additional debt does not offset cash.
An estimated 24.3 percent tax is imposed on the $50,000, or $12,150. There comes a point when in a partial exchange, the tax due if a 1031 exchange is not initiated is close to the tax on the portion of net equity and debt retired not replaced. In that case, the taxpayer needs to decide whether a 1031 exchange still makes sense.
Thirty percent of my consultations result in the outcome not to initiate the 1031 exchange because of a variety of reasons including:
- Want to use the property for personal use that exceeds the fourteen overnight maximum or ten percent of the annual rentals per Revenue Procedure 2008-16
- Want to rent to a family member at below market rates
- Want to receive title different from the relinquished property titleholder
- Do not want to replace the relinquished property net sale price
- Don’t want to have the debt and not willing or unable to provide the cash difference
1031 exchange do make sense and allow taxpayers to easily replace capital assets that are near the end of their useful lives as in equipment, rail cars, aircraft or reposition the asset for better cash flow or appreciation. If you are considering a 1031 exchange, download the free 1031 Point Checklist by clicking on the button below.
