What Does Boot Refer to in an Exchange?
The term boot is commonly used when discussing the tax consequences of an exchange. Unlike property or non-qualifying property such as securities, cash, notes, partnership interests, etc. Taxpayer who receives boot ("unlike" property) will have to recognize gain to the extent of the net boot received or realized gain, whichever is less. Boot is anything that is not considered “like-kind” that the taxpayer receives in an exchange. This could include cash, property other than real property, or net debt relief. Any boot the taxpayer receives is regarded as taxable gain and will trigger a taxable event. There are two categories of boot, mortgage boot or cash boot. A debt instrument that is secured by real estate collateral that the borrower is obligated to pay back over a period of time with a predetermined set of payments, which include both the loan and interest. Mortgage boot refers to the liabilities assumed by the taxpayer. A debt instrument that is secured by real estate collateral that the borrower is obligated to pay back over a period of time with a predetermined set of payments, which include both the loan and interest. Mortgage boot occurs when the exchanger reduces a loan or debt from one property to the other. Cash boot is any cash that the taxpayer receives once the exchange is finalized. It is also important to remember that relief of debt is a taxable event. Here are examples of mortgage and cash boot.
Ms. O’Connell has paid off the mortgage on her property with a value of $100,000. She enters into an exchange and purchases a property with a value of $90,000. Ms. O’Connell receives the remaining $10,000 in cash at the end of her exchange. She receives cash which is cash boot, and Ms. O’Connell will have to pay taxes on the $10,000.
Ms. O’Connell exchanges her property with a value of $100,000 and a mortgage of $50,000. She purchases her replacement property for $90,000 and takes out a loan of $40,000. Because Ms. O’Connell initially had a loan for $50,000 and ultimately ended up with a $40,000 loan, $10,000 less, she has $10,000 in mortgage boot. Even though she never received any cash from the exchange, the mortgage boot is subject to a capital gains tax.
Cash boot can also occur in transactions that involve debt. Suppose a taxpayer places more debt on the replacement property than there was on the relinquished property. The funds held by the Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary are not all used, resulting in excess funds. In that case, the taxpayer will receive the taxable boot. For example:
Ms. O’Connell exchanges her property with a value of $100,000 and a mortgage of $40,000. She purchases a replacement property with the same value of $100,000. Ms. O’Connell takes out a loan of $50,000 and uses $50,000 of the $60,000 held by the qualified intermediary to purchase the replacement property. Although Ms. O’Connell exchanged her property for another of the same value, the $10,000 cash left in the exchange account that she receives is cash boot and considered taxable gain.
Boot Netting Rules
Certain types of boot may cancel out each other, which will lessen their overall impact and reduce the taxable gain. Unlike property or non-qualifying property such as securities, cash, notes, partnership interests, etc. Taxpayer who receives boot ("unlike" property) will have to recognize gain to the extent of the net boot received or realized gain, whichever is less. Boot netting rules include:
Avoiding Taxes Tied to Cash and Mortgage Boot
Credits on a settlement statement directly paid out to the taxpayer result in a taxable event. The credits on a settlement statement can come from various parts of the exchange if not appropriately handled. Here are the few common ones and their solutions:
If a taxpayer pays earnest money out of pocket for a replacement property, the settlement statement will credit the amount back to the taxpayer. This cash return will result in a taxable event. However, if the taxpayer instructs the qualified intermediary to use the exchange proceeds to pay the earnest money, there can be no credit and, therefore, no taxable event. A settlement agent cannot show an offsetting debit line item for an item that the taxpayer did not prepay out of pocket. Suppose the credit shown on the settlement statement includes a credit for property taxes, rent, or security deposit prorations. In that case, the taxpayer should consider asking the seller to pay these items outside of closing. Another option is to ask the closer to show those items as paid outside of the closing and not as a credit line item.
Loan terms can also cause boot. Some lenders and exchangers believe that combining exchange proceeds with a high-balance loan will result in tax-free cash back, and this is not the case. As explained above, any type of credit on a settlement statement after closing will be taxable. To avoid the boot, the taxpayer can lower the loan amount or reduce the principle on the settlement statement for the cashback amount.
When purchasing more than one property, the closer should only credit the buyer the funds needed to buy the property without sending any cashback. The qualified intermediary will hold the remaining funds for use in the additional purchase. If the challenge lies in finding properties to use their remaining exchange funds, call your qualified intermediary. There are various alternative forms of investments that taxpayers do not realize qualify under 1031 exchange rules and may benefit them even more.