What Should You Tell Clients about Taxable Boot?by
Clients who are preparing to conduct a 1031 exchange often ask: Is it possible to have an exchange that is partially taxable? Many ask because they are concerned about whether they will be able to line up a property (or properties) of sufficiently high value.
To achieve full tax deferral in an exchange, clients must spend all of the proceeds from their sale and reacquire any debt paid off. But an exchange does not have to result in this outcome. It’s possible to receive some cash (after the exchange) or have some debt relief and still defer a portion of the tax liability. In this post, we will discuss one of the key topics in Section 1031, the topic of boot.
In technical terms, boot refers to any sort of property received in an exchange that is not of like-kind to the relinquished property. This means it can take a variety of forms, not just cash or debt relief, although these are among the most common types. Here, though, I'll just cover cash boot and mortgage boot.
This kind can be received either voluntarily, such as when a taxpayer wishes to extract cash, or involuntarily, such as when a taxpayer is unable to locate a replacement property of sufficiently high value. In the former situation, taxpayers wish to extract a certain amount of cash in order to finance other purchases. This can be done, but the cash will be taxed to the extent of the gain. In the latter scenario, if a taxpayer owns a property valued at $1 million, with a $500,000 basis, and can only locate replacement properties worth $750,000, then they need to be prepared to pay taxes on the cash that will follow. This is often referred to as "buying down."
As long as the exchange conforms to all of the legal regulations pertaining to receipt, a partial exchange involving cash boot will not result in a failure. In other words, just because cash boot is received doesn’t mean that the remaining gain cannot be deferred.
This type occurs when a taxpayer has an existing mortgage loan that is paid off by the sale and they fail to acquire a mortgage of equal value on the purchase.
Consider this example: A taxpayer owns a property, valued at $1 million, with a $450,000 basis and a mortgage loan of $200,000. When they sell, the mortgage loan will be paid off, so the exchange fund will have approximately $800,000.
However, this doesn’t mean that only $800,000 has to be spent in order to achieve full tax deferral. The taxpayer also has to either acquire a mortgage of at least $200,000 or bring in additional cash to balance out the loan. If they simply use the cash to purchase a property worth $800,000, they will have $200,000 of debt relief, or “mortgage boot,” and this amount would be taxable. To achieve full tax deferral, the taxpayer would need to purchase a property worth at least $1 million and bring in additional cash or acquire a new mortgage loan.
As you can see, there's a good reason clients bring this topic up. They want to know whether they can voluntarily take out cash to finance other things. They also want to know the potential consequences that can follow from a mortgage loan or a buying down in value. The good news is: Partial exchanges are permissible; these won’t necessarily cause the exchange to collapse. But, if full tax deferral is the goal, that taxpayer needs to understand how boot works and how it can avoided.
Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.