The Rules of "Boot" In a § 1031 Exchange
A taxpayer must not receive "Boot" from an exchange in order for a Section 1031 exchange to be completely
tax-free. Any boot received is taxable (to the extent of gain realized on the exchange). This is okay
when a seller desires some cash and is willing to pay some taxes. Otherwise, boot should be avoided in
order for a 1031 Exchange to be tax-free.
The term "boot" is not used in the Internal Revenue Code or the Regulations, but is commonly used in
discussing the tax consequences of a Section 1031 tax-deferred exchange. Boot received is the money or
the fair market value of "other property" received by the taxpayer in an exchange. Money includes all
cash equivalents plus liabilities of the taxpayer assumed by the other party, or liabilities to which
the property exchanged by the taxpayer is subject. "Other property" is property that is non-like-kind,
such as personal property received in an exchange of real property, property used for personal purposes,
or "non-qualified property." "Other property" also includes such things as a promissory note received
from a buyer (Seller Financing).
Boot can result from a variety of factors. It is important for a taxpayer to understand what can result
in boot if taxable income is to be avoided. The most common sources of boot include the following:
-
Cash boot taken from the exchange. This will usually be in the form of "net cash received", or
the difference between cash received from the sale of the exchange property and cash paid to acquire the
replacement property or properties. Net cash received can result when a taxpayer is "trading down" in
the exchange so that the replacement property does not cost as much as the exchange property sold for.
-
Debt reduction boot which occurs when a taxpayer’s debt on replacement property is less than the debt
which was on the exchange property. As with cash boot, debt reduction boot can occur when a taxpayer is
"trading down" in the exchange.
-
Sale proceeds being used to service costs at closing which are not closing expenses. If proceeds of
sale are used to service non-transaction costs at closing, the result is the same as if the taxpayer
received cash from the exchange, and then used the cash to pay these costs. Taxpayers are encouraged to
bring cash to the closing of the sale of their property to pay for non-transaction costs.
-
Borrowing more money than is necessary to close on replacement property will cause cash being held by an
Intermediary to be excessive for the closing. Excess cash held by an Intermediary is distributed to the
taxpayer, resulting in cash boot to the taxpayer. Taxpayers must use all cash being held by an
Intermediary for replacement property. Additional financing must be no more than what is necessary, in
addition to the cash, to close on the property.
-
Loan acquisition costs with respect to the replacement property which are serviced from exchange funds
being brought to the closing. Taxpayers usually take the position that loan acquisition costs are being
serviced from the proceeds of the loan. However, the IRS may take a position that these costs are being
serviced from Exchange Funds. This position is usually the position of the financing institution also.
-
Non-like-kind property which is received from the exchange, in addition to like-kind property
(real estate). Examples of non-like-kind property include seller financing (promissory note) or
irrigation equipment.
|
Copyright
