In order to defer all capital gains and depreciation recapture taxes from the sale of a relinquished property, a taxpayer must purchase a replacement property with an equal or greater value than the property sold. Any debt reduction or proceeds that are not reinvested may be considered boot, which can create a taxable event.
Boot refers to any non-like-kind property received as part of a 1031 exchange that does not qualify for tax deferral. Examples may include cash, notes, partnership interests, securities, inventory, or property held primarily for sale rather than investment purposes.
There are two primary types of boot:
- Cash boot: Any cash received during the exchange.
- Mortgage boot: Any reduction in debt or mortgage liability on the replacement property compared to the relinquished property.
Any boot received during a 1031 exchange may be subject to taxation as either depreciation recapture or capital gain.
It is also important to understand that credits shown on a settlement statement and paid directly to the taxpayer can create boot and trigger a taxable event. If a 1031 exchange is not structured or administered properly, these credits can unintentionally arise during closing. Common examples include:
Earnest Money Deposits
If earnest money is paid out of pocket by the taxpayer, it may appear as a credit on the settlement statement. To help avoid this issue, earnest money should generally be paid by the qualified intermediary using exchange proceeds whenever possible.
Property Taxes, Security Deposits, and Rent Prorations
Credits related to property taxes, security deposits, or rent prorations may also be considered taxable boot. Taxpayers may wish to negotiate with the seller to settle these items outside of closing when appropriate.
Key Takeaway
To fully defer taxes in a 1031 exchange, taxpayers generally must reinvest all net proceeds and acquire a replacement property of equal or greater value than the relinquished property. While it is possible to take cash out of the exchange, doing so creates boot and may result in taxes on the amount received. Understanding how boot is created can help investors maximize the tax-deferral benefits of a 1031 exchange.