Causes of 1031 Exchange Boot
In a 1031 Exchange, “boot” refers to any cash or non-like-kind property received by the taxpayer during the exchange. The receipt of boot triggers a taxable gain, which may jeopardize some of the tax-deferral benefits of the exchange. California real estate investors—where gains can be substantial—should understand the various factors that can result in unplanned boot.
Cash Boot
Cash boot can occur when an exchanger fails to invest all profits from their property sale into a like-kind asset or fails to transfer any gains to the Qualified Intermediary facilitating their exchange. Additionally, cash boot can accumulate from the interest earned on sale proceeds while acquiring a replacement property or if sale proceeds are used to service non-transaction costs at closing. To avoid cash boot, investors should consider bringing cash to the closing of the sale of their relinquished property to pay for non-transaction costs.
Mortgage Boot
Referred to as either a debt reduction boot or a mortgage boot, this type of boot is the result of an uneven 1031 Exchange that ultimately leads to a mortgage or debt reduction. This can occur when an investor acquires a replacement property with a smaller mortgage than their relinquished property—even if all sale proceeds are used to purchase the property. Despite following all other exchange-related rules, the decrease of debt liability upon acquiring a replacement property constitutes mortgage boot, which is subject to taxation.
Non-Like-Kind Property
Receipt of assets such as stocks, bonds, or personal-use property instead of like-kind real estate can qualify as boot. Because the inclusion of personal or non-like-kind property can often happen accidentally, it’s important to clearly state which items are included and excluded from the sale.
Prorated Rents and Security Deposits
Occasionally, the purchase of rental property will include prorations for expenses like prepaid rent and/or security deposits. The addition of a prorations clause to the purchase and sale agreement can help determine how any prorations will be handled. This is a detail Sacramento investors frequently overlook—one that can have real tax consequences.
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Using DSTs to Mitigate 1031 Exchange Boot
Delaware Statutory Trusts (DSTs) offer a potential solution for avoiding boot and unnecessary tax liability. By reinvesting excess cash or debt boot into a DST, California investors can maintain the tax deferral benefits of their exchange and gain the potential for passive income.
At Legacy, we work with you to build a 1031 Exchange strategy tailored to your unique goals and specific needs. Give our knowledgeable team a call to learn more about the potential benefits of utilizing the Delaware Statutory Trust to mitigate boot.
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There are material risks associated with investing in private placements, Delaware Statutory Trusts (“DSTs”) and real estate securities including the potential loss of the entire investment principal, illiquidity, tenant vacancies impacting income and revenue, general and real estate market conditions, lack of operating history, interest rate risks, competition, including the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and investors should read the PPM carefully before investing paying special attention to the risk section. This material is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Legacy Investments & Real Estate is independent of CIS and CAM.