A 1031 exchange isn’t an all-or-nothing proposition. It’s possible to conduct a successful 1031 exchange, but still owe some capital gains tax on the transaction — when this happens, the taxable portion of the deal is known as a “boot.”
While some exchangers will consider it a worthwhile trade-off to pay some tax in exchange for cashing out equity, the goal of most 1031 exchanges is to defer all taxes on the transaction. To accomplish this, you must understand the scenarios that generate boot and how to avoid them.
The preceding figures assume an all-cash exchange. Things become slightly more complicated when mortgages are involved.
Consider an exchange scenario in which you sell relinquished property valued at $500k, with an existing mortgage of $350.000, which is repaid in full at closing. You then acquire a replacement property valued at $600,000 and make a 20% cash down payment — meaning that the new mortgage on the replacement property is $480,000. In this case, you have taken $150k in equity out of the relinquished property and only reinvested $120,000. You’ve effectively cashed out $30,000 in equity, creating a net taxable cash boot even though the replacement property value was higher.
Just as you must avoid cashing out equity, you must also avoid reducing your debt obligations in a 1031 exchange.
Consider this scenario: You sell relinquished property valued at $500,000, with existing mortgages of $350,000. You then acquire replacement property valued at $450,000, and you know from the example above that you need to reinvest all of your equity ($150,000) into the new property, so you take out a mortgage of $300,000.
In this case, even though you rolled all of your equity forward, you have benefitted from debt relief in the process ($300,000 vs. $350,000), so you’ve generated a $50,000 boot.
Note that you can reduce your debt obligation and still defer tax, but you need to offset it by adding cash. If in the case above the replacement property was valued at $500,000 (instead of $450,000) you could take out the same mortgage of $300,000, but offset the $50,000 in debt relief ($300,000 vs. $350,000) by adding $50,000 cash to the purchase to offset the net debt relief.
If your goal is a 100% tax-free 1031 exchange, be sure to engage a 1031 qualified intermediary (QI) with a proven track record. Your QI should help you carefully structure your exchange to avoid surprises.
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