Tom Moore, co-founder and President of Equity Advantage, often sees investors surprised by taxes that can arise during a 1031 Exchange. Although 1031 Exchanges are a great tool for tax deferral, there are some small mistakes investors often make that will cause unexpected taxes, such as filing a tax return before the Exchange is complete or receiving boot from an Exchange. So, Tom Moore recently explains how to avoid these mistakes to prevent unexpected taxes and make the most of your 1031 Exchanges.
Your Tax Return Deadline Matters
One issue investors often overlook is how their tax filing deadline lines up with the 180-day Exchange deadline. Tom Moore points out that if your tax return is due before your 180 days are complete, you may face a reporting challenge.
You cannot file your tax return without reporting the status of the Exchange. If the Exchange is still open and unfinished, you may not have all the details required to accurately file your return. In that situation, you may need to file for an extension so the Exchange can be completed before your taxes are finalized.
This does not change the rules of the 1031 Exchange itself, but it does affect how and when you file your return. Planning for this timing issue early can help prevent unnecessary complications.
What Is Boot in a 1031 Exchange?
Tom Moore explains that boot is anything you receive in an Exchange that is not like-kind real estate. Cash is the most common example, but boot occurs when you receive something that does not qualify as replacement real estate.
Boot matters because it is taxable. While a 1031 Exchange allows for tax deferral on qualifying real estate, boot does not receive that same treatment. Any boot you receive is taxed in the year you receive it.
Understanding what qualifies as boot helps investors identify where taxes may still apply, even when an Exchange is structured properly.
Receiving Cash Boot at Closing
A common scenario Tom Moore describes involves an investor selling a property and choosing to pull cash out of the transaction at closing. This approach is allowed within a 1031 Exchange, but it comes with tax consequences.
When you take cash at closing, that cash becomes boot. Because you receive it in the year the sale closes, it is taxable in that same year. Even if you reinvest the rest of the proceeds into replacement property, the cash you take out does not qualify for tax deferral.
This is why investors should carefully consider how much cash, if any, they want to receive when completing the sale portion of an Exchange.
Boot Received After the Exchange Is Completed
Tom Moore also explains that boot is taxed based on when you receive it, which means timing can affect which tax year is impacted. If an Exchange is completed in a later year and you receive boot at that time, the tax may apply in that later year.
For example, if the sale occurs in one year but the Exchange concludes in the following year and you receive boot then, you may owe tax on that boot in year two. The tax does not disappear, but the timing of when you owe it can change.
Knowing when you expect to receive boot allows investors to better anticipate their tax obligations.
Debt Relief as Taxable Boot
Debt relief can also create taxable boot, with the net amount being typically taxed in the year the sale takes place.
Debt relief occurs when the debt on the relinquished property exceeds the debt placed on the replacement property. That net difference becomes taxable boot. In most cases, investors recognize this taxable boot in the year the sale occurs, even if the Exchange itself continues afterward. This often catches investors off guard, especially when they focus only on cash received and overlook how debt is handled in the Exchange.
Get the Most from Your 1031 Exchange
A 1031 Exchange involves more than simply purchasing replacement property. Timing, reporting, and what you receive during the transaction all affect your tax outcome.
Boot is taxable whether it comes from cash or debt relief. If you’re looking to maximize your tax deferral, your best choice is to avoid boot as much as possible. However, if you’re fine with receiving boot, it’s important to note that the year you pay tax on that boot depends on when you receive it. If your Exchange is still open when your tax return is due, you may need to file an extension.
Being aware of these potential mistakes is the first step to making sure your 1031 Exchange goes smoothly, but we always recommend talking to an expert to ensure your Exchange provides the tax deferral benefits you’re hoping for. If you’re looking to start a 1031 Exchange or need expert advice on how to maximize your Exchange, reach out to the team at Equity Advantage today.
The Guys With All The Answers…
David and Thomas Moore, the co-founders of Equity Advantage & IRA Advantage
Whether working through a 1031 Exchange with Equity Advantage, acquiring real estate with an IRA through IRA Advantage or listing investment property through our Post 1031 property listing site, we are here to help Investors get where they want to be. Call them today! 503-635-1031.
