A 1031 exchange allows real estate investors to defer capital gains taxes when selling one property to buy another. However, specific actions during this process can create a “boot,” which is taxable. Knowing how these actions can trigger boot is key to maximizing the tax benefits of your exchange. In this article, we’ll review several scenarios that can create boot: paying down a loan to zero, closing costs from sale proceeds, and prorated taxes.
What Is A 1031 Exchange?
A 1031 Exchange is a tax rule that helps people who sell investment property save money on taxes. You must pay taxes on your profit when you sell an investment property, like a rental house or office building. However, with a 1031 Exchange, you can delay those taxes if you use the proceeds from the sale to buy another investment property.
The “exchange” part means you’re swapping one investment property for another. The key is the new property must be of “like kind” which means it has to be used for business or investment purposes not personal use. You also have to follow rules. For example you have to identify the new property you want to buy within 45 days of selling the old one and close on the new property within 180 days.
Remember, even though the seller doesn’t “touch” the proceeds when their loan is paid off a closing, it is still considered boot and subsequently taxable.
What Is Boot In A 1031 Exchange?
In the context of a 1031 exchange, “boot” refers to any non-like-kind property received in the transaction. This includes cash, personal property, and certain financial adjustments that result in taxable income. The IRS treats certain transactions as if cash was received, impacting your tax situation.
- Pay Down of Loan to $0: One of the most significant ways to incur boot is by paying down the loan on your relinquished property to zero using sale proceeds.
- Example Scenario:
- Sale Price: You sell your investment property for $600,000, which has an outstanding mortgage of $200,000.
- Loan Pay Down: You decide to use $200,000 from the sale proceeds to pay off the mortgage entirely.
- In this case, the full amount paid off ($200,000) is considered boot. This amount is treated as cash received and will be subject to capital gains taxes.
- Closing Costs Paid from Sale Proceeds: Another way boot can arise is through closing costs that are paid directly from the sale proceeds. While some closing costs can be part of the transaction without triggering boot, specific fees can lead to taxable income.
- Example Scenario:
- Sale Proceeds: $600,000
- Closing Costs: $30,000
- If these costs are deducted from the sale proceeds, they can create boot. The effective amount you reinvest is only $570,000, meaning the $30,000 in closing costs may be considered boot, impacting your tax liability.
Proration of Taxes Paid with Sale Proceeds: Prorated property taxes can also result in boot if they are paid using sale proceeds. When you sell a property, the seller often pays the prorated share of property taxes up to the closing date. If you use sale proceeds to cover these taxes, it can be treated as cash received.
- Example Scenario:
- Sale Proceeds: $600,000
- Prorated Taxes: $5,000
- If you pay $5,000 in prorated taxes from your sale proceeds, this amount is considered boot. The total amount available for reinvestment in the new property is reduced to $595,000.
Summary of Boot Implications
- Even without receiving cash directly, actions that reduce your investment or cover costs can trigger boot. Here’s a recap of the main points:
- Pay Down of Loan: Using sale proceeds to pay down a mortgage creates boot, treated as cash received.
- Closing Costs: Fees deducted from sale proceeds reduce the amount available for reinvestment, leading to taxable boot.
- Prorated Taxes: Paying property taxes from sale proceeds is also considered boot.
Learn More About 1031 Exchange Options
A 1031 exchange is tricky, especially regarding boot and what it means. Knowing how paying down a loan, covering closing costs, and paying prorated taxes can create taxable boot is essential to making smart investment decisions. Talk to a qualified intermediary or tax advisor to manage your tax and get smart.
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