What Is Boot in a 1031 Exchange and How Do I Avoid It?

Boot is anything you receive in a 1031 exchange that is not like-kind real estate: cash you keep, debt you are relieved of and do not replace, or other property such as furniture or a promissory note. You pay tax on your gain up to the amount of boot, and the rest of the gain stays deferred. To avoid boot entirely, buy replacement property worth at least as much as the one you sold, reinvest every dollar of net proceeds, and replace any mortgage you pay off with new debt or your own cash.

The three kinds of boot

Section 1031 of the Internal Revenue Code says that if you receive money or other property along with like-kind property, you recognize gain, but not more than the money plus the fair market value of the other property. In practice, boot comes in three forms:

• Cash boot. Exchange funds paid to you, at closing or later. This includes money the qualified intermediary (QI), the company holding your sale proceeds, releases to you because you bought a cheaper property.
• Mortgage boot (debt relief). When the buyer pays off or takes over your old mortgage, the IRS treats that debt relief as money you received. If your new mortgage is smaller and you do not add cash to make up the difference, the shortfall is boot.
• Other property. Anything that is not real estate, such as furniture or equipment that comes with the replacement property, or a note the buyer gives you for part of the price.

You cannot deduct a loss in an exchange.

Boot is usually taxed for the year of the exchange. Two exceptions change when you pay. If the buyer gives you a note, IRS Publication 537 says you report that part of the gain as payments arrive, under the installment sale rules. And if your exchange spans two tax years, cash the qualified intermediary releases to you in the second year can generally be reported in that year.

How boot is taxed: worked examples

Both examples ignore closing costs to keep the math simple. In a real exchange, exchange expenses you pay, such as commissions and title fees, reduce the boot you are taxed on, as Form 8824 shows. Loan fees and amounts set aside for future taxes and insurance on the new mortgage are not purchase costs under IRS Publication 551, so do not count on them to offset boot.

Example 1: cash boot. You sell a rental for $500,000. Your adjusted basis, what you paid plus improvements minus depreciation, is $300,000. Your realized gain is $200,000. There is no mortgage, so the QI holds $500,000. You buy a replacement for $440,000, and the QI sends you the remaining $60,000.

• Realized gain: $500,000 minus $300,000 = $200,000
• Boot received: $60,000
• Taxable gain this year: the smaller of $200,000 and $60,000 = $60,000
• Gain still deferred: $200,000 minus $60,000 = $140,000
• Basis in the new property: $440,000 minus $140,000 = $300,000

Example 2: mortgage boot. You sell the same rental, with the same $300,000 basis and $200,000 gain, for $500,000. It has a $200,000 mortgage, which is paid off at closing. The QI receives the other $300,000. You buy a $450,000 replacement using the $300,000 plus a new $150,000 loan.

• Old debt paid off: $200,000
• New debt taken on: $150,000
• Net debt relief: $50,000, which is boot
• Taxable gain this year: the smaller of $200,000 and $50,000 = $50,000

You did not receive any cash in Example 2, but you still owe tax, because you traded down from $500,000 of property to $450,000.

On a rental you have depreciated, part or all of the taxable gain may be unrecaptured section 1250 gain, the part of your gain that comes from depreciation deductions, which is taxed at up to 25%. Other long-term gain is taxed at 0%, 15%, or 20% depending on your income. Recognized investment-property gain may also be subject to the 3.8% net investment income tax. That tax applies to the smaller of your net investment income or the amount your modified adjusted gross income exceeds $200,000 if single or head of household, $250,000 if married filing jointly, or $125,000 if married filing separately. You report the exchange and any taxable boot on IRS Form 8824.

How to defer all of the tax

Follow these four rules, all measured against the property you sold:

1. Buy property of equal or greater value. Compare the replacement's price with the old property's sale price minus selling costs. If the replacement costs less, the difference shows up as cash boot, debt relief, or both.
2. Reinvest all net proceeds. Every dollar the QI holds must go into the replacement property. Do not take money out at closing, and do not have the QI pay you a leftover balance.
3. Replace the debt you pay off. New debt on the replacement property offsets old debt paid off. Cash you add from your own pocket also offsets it. In Example 2, buying a $500,000 replacement instead, with the $300,000 of exchange funds plus either a $200,000 new loan or a $150,000 loan and $50,000 of your own cash, would have eliminated the boot. The offset does not work in reverse: taking on a larger new loan does not cancel cash you take out of the exchange.
4. Pay only closing costs from exchange funds. Treasury rules allow exchange funds to pay transaction costs that normally appear on a closing statement, such as sales commissions, title company fees, and transfer taxes. IRS Publication 544 says other items that can appear on a closing statement, such as rent prorations, security deposits, and repairs, are not exchange expenses. The IRS treats you as receiving money when you get its benefit, so using exchange funds for these items, or receiving a credit for them, can create taxable boot.

Have your QI and tax preparer review both closing statements before you sign, line by line, including tenant security deposits and rent prorations credited to the buyer.

When accepting boot can make sense

A partial exchange can be a deliberate choice. If you need $60,000 in cash, taking it as boot in Example 1 means paying tax on $60,000 while still deferring $140,000, instead of paying tax on the full $200,000 in an outright sale.

If you want cash but do not want to pay tax on boot, a loan is a separate option. Borrowing against the replacement property after the exchange is a financing decision with its own interest and closing costs; see what it means to refinance a mortgage. Ask your tax adviser before arranging any loan that closes as part of the exchange itself.

What the rest of the exchange must meet

Boot only matters if the rest of the exchange qualifies. Both properties must be U.S. real estate held for business or investment; see which property types qualify. You must identify the replacement in writing within 45 days and close within 180 days or by your tax return due date, including extensions, if that comes first, as explained in what a 1031 exchange is. If you receive, or can draw on, all the sale proceeds before you buy, the IRS treats the deal as a taxable sale, and receiving part of them makes that part taxable. That is why you need a qualified intermediary. For how the exchange fits with other homeowner tax rules, see tax benefits available to homeowners.