In a 1031 Exchange, many investors wonder how receiving cash or experiencing debt relief affects their tax liability. Although Exchanges work to defer capital gains, certain transactions can actually create taxable events, such as taking cash out of the transaction, which becomes “boot.” Tom Moore, co-founder and President of Equity Advantage, explains how boot works and how the timing of cash or debt relief can affect when taxes are owed.
What is “Boot” and How Does it Affect Your 1031 Exchange Taxes?
In a 1031 Exchange, “boot” refers to any value or money you receive from the sale of your property that is not reinvested into your replacement property. This includes cash taken out at closing or relief from debt. Boot can trigger taxes even when a 1031 Exchange is otherwise completed to defer capital gains.
Cash Boot Timing Matters
Tom Moore points out that if you sell a property and take cash out at closing, that amount is considered boot received in the first year when the sale closes. For instance, if you sell an investment property and withdraw some proceeds, that cash is taxable in the year of the sale.
Sometimes the timing can differ. If the exchange process continues and you receive cash boot in the following year, it may be taxed in that second year. The IRS taxes boot when it is actually received, so the year you take possession of cash matters.
Debt Relief as Boot
Boot is not just cash. Debt relief can also be taxable boot. Tom Moore explains that when debt is paid off as part of the sale, such as a mortgage at closing, that debt relief is usually taxed in the year the sale occurs.
For example, if you have a property with an outstanding loan, when escrow closes and the debt is paid off, the reduction in liabilities counts as boot. It is generally taxable in that year because you gained value without reinvesting it into the replacement property.
No Cash Received? Watch for Debt Differences
Tom Moore highlights a scenario that can be confusing. If you complete a 1031 Exchange without taking any cash, you might think there is no boot. That is true only if your debt situation remains consistent.
For example, if the replacement property costs the same as the sold property and no new debt is incurred, you do not receive boot. However, if the original property had debt that is relieved during the transaction but you do not take on a comparable loan for the new property, that debt relief is considered boot. Even though no cash changes hands, the value of debt reduction is treated as received value and thus becomes taxable boot.
Important Things to Consider When Planning for a 1031 Exchange
- Cash Boot is Taxable When Received: Any cash taken out at closing is taxed in the year of the sale. If received later, the tax may apply in that later year.
- Debt Relief Counts as Boot: Any debt paid off during the sale is taxable in the year that escrow closes.
- Debt Matching Matters: To avoid unintentional boot, make sure that the financing on the new property mirrors that of the old property. Reducing your overall debt is considered a gain in value and therefore counts as a taxable boot, even if you do not actually receive any cash.
- Timing Drives Taxation: When you need to pay tax on your boot, the IRS considers the year that you actually receive the funds to be the year you will pay the tax in. If the exchange process continues past the end of the year and you receive cash boot in the second year, it may be taxed in that second year, not the first.
Planning Ahead to Minimize Taxes in Your 1031 Exchange
Understanding boot in your 1031 Exchange is key for investors who want to fully defer any taxes on real estate gains. While cash and debt relief are considered forms of boot and will be taxed, carefully planning the sale and the financing of replacement properties can help investors effectively reduce any unexpected tax liabilities and make the most of their Exchange.
Unsure of what is considered taxable boot in your 1031 Exchange or how timing will affect your tax liability? Reach out to the team at Equity Advantage today to speak with an expert.
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.
