A 1031 exchange is a legal method of deferring capital gains taxes when selling an income property.
By selling income property and reinvesting the proceeds in a “like-kind” property, investors can use the property’s equity to purchase one or more replacement properties.
For investors, using a 1031 exchange is like getting an interest-free loan from the government. That’s because, with a properly structured exchange, you can defer your capital gains taxes indefinitely.
There are several important rules that you must follow to ensure you don’t get hit with capital gains taxes.
One of them, called “boot,” is commonly misunderstood by investors.
What Is “Boot?”
The term boot describes the additional money on an investment which can make the value of the properties equal.
The IRS stays that investors are not allowed to receive “boot” in a 1031 exchange. “Boot” is a property that is not like-kind. For CRE investors, like-kind properties are income properties that include offices, retail, net lease, industrial, shopping centers, apartments, condominiums, duplexes, and raw land.
When Does A “Boot” Occur?
Non-like-kind property is usually cash or mortgages, and so these are termed 1031 exchange boot. A mortgage boot occurs when the new property you invest in has a lower mortgage than the old property.
The difference would be taxable unless you either add cash back to the deal or finance the income property through a new loan after the exchange is complete. You shouldn’t try and refinance the property you are about to sell, as the IRS rules that any cash received would be taxable.
A cash boot can occur when earnest money is paid from the proceeds of the exchange.
Why You Shouldn’t Pay Closing Costs From Your Income Property Proceeds.
In order to avoid dealing with capital gains taxes, it’s a good idea to pay items like earnest money, rent prorations, property taxes, utility escrow charges, tenant damage deposits, or prorations outside of closing, rather than being written down as a credit line item.
A cash boot can also occur when the investor has two properties that are not equal in value. In a standard 1031 exchange that difference would be made up by one of the parties, depending on which side the difference lies on.
A deferred exchange, on the other hand, requires that all the proceeds of the sale of the original property be invested directly in the replacement property. Otherwise, anything leftover will be considered subject to capital gains taxes.
Here’s what to do to ensure you don’t become liable to pay capital gains taxes in a 1031 exchange:
Keep These Three Boot Rules In Mind When Using A 1031 Exchange
- Always use the proceeds of your investment property sale to buy a property of equal or greater value.
- Bring cash to the closing of the relinquished property to pay for any costs which aren’t considered transaction costs.
- Make sure your financing on the exchange property is of equal or greater value than the relinquished income property.
