Articles

"Boot"

By: Neil L. Friedman

Contrary to popular belief "boot" has nothing to do with footwear or pirate's booty. "Boot" is an Old English term used in the context of a 1031 tax deferred exchange to describe any property received by the exchanger, during an exchange, which is not "like-kind" to the property being sold. For tax purposes "boot" is defined as the "fair market value" of the non-qualified property received in an exchange. In most Real Property exchanges, "boot" typically takes the form of cash. It can also be personal property such as a boat or equipment or nonqualified property such as stocks, bonds, notes, partnership interests or debt reduction as in "mortgage boot".

A tax deferred 1031 exchange is not an all or nothing proposition. The receipt of "boot" will not, on its own, disqualify the exchange. Cash "boot" typically occurs at closing when the exchanger elects to take some cash. It can also occur at the end of the exchange period (180th day) when the qualified intermediary is required to return to the taxpayer any cash remaining in the exchange account that the exchanger has failed to reinvest.

Many exchangers mistakenly believe they can take their original investment back and only reinvest their gain. The fact is that the every dollar taken as "boot" is treated as gain until all the gain is exhausted. If a taxpayer has depreciated his investment property, every dollar of "boot" is first subject to the 25 percent depreciation recapture rate until all the depreciation recapture is collected. Then any remaining "boot" is taxed at the 15 percent long term capital gains rate. The exchanger may also be subject to state, county, or city income tax on their "boot" as well.

If an exchanger wishes to avoid the receipt of "boot" and have a 100 percent tax deferral, their exchange must be in balance. That is, they must meet the following three requirements:

• They must purchase replacement property of equal or greater value (net sales price) to the property they sold.

• They must reinvest all the net equity (exchange funds) from the sale.

• They must obtain equal or greater debt, on the replacement property, than was paid off or assumed on their relinquished property.

Failure to replace all the debt is considered by the IRS to be "mortgage boot". "Mortgage boot" is particularly onerous because a taxpayer is deemed to have incurred a tax obligation but has no cash to pay it. One way a taxpayer can avoid "mortgage boot" and reduce the amount of debt needed to balance an exchange is to invest more of their after-tax cash in the replacement property. In other words, cash can cure "mortgage boot."