Boot is the #1 reason exchanges go partially taxable. Here's exactly how to eliminate it.
Boot is any non-like-kind property or value you receive during a 1031 exchange. The IRS taxes boot up to the amount of your recognized gain. There are two main types:
Cash Boot: proceeds from the sale of your relinquished property that aren't reinvested in the replacement property. If you sold for $1M and only reinvested $900K, you have $100K of cash boot.
Mortgage Boot: also called debt relief boot. If your relinquished property had $500K of debt and your replacement property only has $300K, you have $200K of mortgage boot.
To eliminate boot entirely, follow these two rules:
1. Reinvest all your proceeds. Every dollar of net equity from the sale must go into the replacement property.
2. Replace your debt. The replacement property's mortgage must equal or exceed the relinquished property's mortgage.
If you can't replace debt with debt, you can substitute additional cash, but it doesn't work in reverse. You can't eliminate cash boot by adding more debt.
Closing costs. Most closing costs on the replacement side can be paid from exchange funds without creating boot, including title insurance, escrow fees, recording fees, and real estate commissions. But pre-paid items, loan origination fees, and property tax prorations generally cannot. Know which costs are "qualified" before closing.
Personal property. If the seller includes appliances, furniture, or equipment in the sale and you're paying for it with exchange funds, that personal property is not like-kind to real property: it's boot.
Earnest money. If you put down earnest money from your own pocket (not exchange funds), you'll need to be reimbursed at closing through exchange proceeds, otherwise the personal funds paid create complexity.
Reduction in value. If your replacement property is worth less than your relinquished property, the difference is treated as boot regardless of how much cash you put in.
Yes, a partial exchange is allowed. You can take cash out, but it's taxable that year. Many investors do this intentionally to fund renovations on the replacement property or cover living expenses. Just know that you'll owe capital gains on whatever you take out.
Boot is almost always avoidable with proper planning. The key is to work with your Qualified Intermediary and CPA before closing, not after. Run the numbers on both debt and equity before you sign anything.
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