A 1031 exchange boot is taxable. In other words, if you don’t handle the exchange properly, you could be faced with a tax bill.
While many 1031 exchanges are successful and profitable for those involved, even small mistakes can come with big consequences. That’s why it’s so important to understand how these transactions work and how to do them properly.
What Is a 1031 Exchange Boot?
As the Internal Revenue Service (IRS) explains, anything you get within the 1031 exchange that is not like-kind property is taxable. Another word for this is boot.
Think of a boot as a form of cheating. You entered a transaction with the intent of trading one entire property for another entire property. Instead, you sheared off some part of the money generated by the sale—either intentionally or unintentionally—and kept it. You’ve generated boot.
Why Should You Avoid a 1031 Exchange Boot?
The National Society of Tax Professionals explains that the presence of boot triggers an immediate tax liability. In other words, if a boot exists, you have to pay taxes on it.
Most people use a 1031 exchange to avoid the tax consequences associated with selling commercial real estate. By generating boot, you remove some of those benefits, as you’re required to pay at least some taxes.
8 Ways to Minimize a 1031 Exchange Boot
While it’s clear that a boot is a negative thing, it’s certainly not inevitable. In fact, by following a few basic principles, you can ensure that you keep your potential boot as small as possible (and your profits as big as they can be).
Here’s what you should try:
1. Choose the Right Single Property
The quickest and easiest way to avoid a 1031 exchange boot is to purchase a property that costs more than the one you’re selling. With this method, you roll the entire profits from the sale into the purchase of the new one, and no boot is generated.
2. Purchase Multiple Properties
You’re not required to buy just one property via a 1031 exchange. You can use this method to purchase two properties that (when put together) cost more than the one you’re selling. With this technique, you don’t generate any boot at all.
3. Invest in a DST Exchange
Some investors identify a dream property to purchase in the exchange, but it’s not worth more than the one that was sold. In this situation, an investor could participate in a Delaware statutory trust (DST). IRS rules created in 2004 state that some DST products (but not all) can be used in an exchange process like this and meet 1031 exchange requirements.
If you choose this option, ensure you’re working with a professional that understands how DSTs work within exchanges.
4. Deal Only With Property
In the past, investors could wrap up non-property items like artwork or stocks into an exchange. That changed in 2018 when the IRS ruled that non-property items could be considered boot.
While it might be tempting, don’t include the following items in your 1031 exchange documents, including your purchase agreements:
Machinery
Collectibles
Vehicles
Equipment
Artwork
Patents
If you want to purchase these items, create a separate agreement that sits outside of your 1031 exchange, and use separate funds to complete the deal.
5. Don’t Live in the Property
A 1031 exchange is designed for commercial properties. Houses, apartments, and other assets you intend for personal use don’t qualify as a like-kind exchange, says the IRS.
You could generate a 1031 exchange boot with a simple issue, such as buying an apartment complex and choosing to live in one of the units. The one you live in could be considered boot, and you could be taxed on it.
6. Pay Attention to Mortgages
The National Society of Tax Professionals explains that some mortgage decisions can generate boot. For example, if the mortgage on the replacement is smaller than the one you sold, the reduction in debt is a boot.
It’s reasonable to want to reduce your debt load, but watch the numbers carefully. Ensure that you don’t reduce your mortgage enough to generate taxes that wipe out your potential financial gains.
7. Don’t Use Proceeds the Wrong Way
A typical transaction involves several other expenses. For example, you may have legal fees, association fees, or insurance costs. While these are legitimately tied to buying a property, you can’t use 1031 exchange funds to cover them. If you use money in these ways and get caught, you could trigger a tax bill.
8. Use a Qualified Intermediary
The IRS has very strict rules about receipts. If you accept money within a 1031 exchange—even if you never intended to take it—those funds are considered boot. Hiring a qualified intermediary ensures that the funds from the sale never hit your accounts. That simple step ensures you don’t trigger boot, and it keeps your transaction in the clear.
Help for Your 1031 Exchanges
A 1031 exchange transaction is complex, and it’s very easy to make mistakes at some point in the process. Let the talented team at 1031 Pros guide you through the process and protect your time and investment. We specialize in these transactions, and we’ve helped thousands of investors just like you. Contact us to get started today.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
What Is Boot in a 1031 Exchange? National Society of Tax Professionals.
Understanding Why More Non-Traded REITs and Real Estate Funds Are Adopting a DST Structure as Part of a Capital Raise. (September 2023). National Law Review.
Like-Kind Exchanges: Real Estate Tax Tips. (August 2024). Internal Revenue Service.
What Is Boot in 1031 Exchanges? (February 2024). LeaderBank.
Depreciate Property in Like-Kind Exchanges Consistently. (October 2008). Journal of Accountancy.
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