For many years, real estate investors have utilized 1031 exchanges as a means of delaying the payment of capital gains tax arising from the sale of investment properties. To achieve complete deferral of capital gains taxes on any profits realized, investors are required to reinvest the full sale proceeds from their relinquished assets. Funds that remain uninvested are categorized as "boot" and attract tax liabilities.
This article delves deeper into two types of boot, namely cash and mortgage boot, and explores how they are generated during a 1031 exchange.
For many investors, the primary objective of engaging in a 1031 exchange is to defer capital gains taxes that result from the sale of investment properties. However, receiving cash from the sale and reinvesting less than the full sale proceeds into the replacement asset can generate a taxable event. For example, if an investor reinvests only $900,000 of a $1 million sale, the remaining $100,000 would be considered cash boot and subject to capital gains tax liability.
The amount of tax liability depends on the investor's income and tax filing status. If the investor is in the 0% tax bracket, there is no tax liability, but if they are in the 15% or 20% bracket, the tax liability on a $100,000 cash boot would be $15,000 or $20,000, respectively.
In addition, if the investor held the asset for a short-term period, the tax liability could be even higher, as short-term capital gains are taxed as ordinary income at the investor's marginal tax rate, which could be up to 37%.
If an investor does take cash out of a 1031 exchange, they can replace it with cash boot paid during the closing on the replacement asset. However, any net cash boot received will always generate a taxable event. It's important for investors to carefully consider the tax implications of taking cash out of a 1031 exchange and to consult with a tax professional to fully understand the potential consequences.
In a 1031 exchange, generating boot is not limited to taking cash proceeds out of the exchange. Mortgage boot, also known as debt boot, can be created if the debt on the replacement asset is less than the debt on the relinquished property.
For example, let's say you sold your relinquished asset for $1 million and had a mortgage of $250,000, which was paid off at the close of sale. You then rolled the entirety of the sale proceeds into a replacement asset, but the mortgage on your replacement property was only $200,000. This means that you generated $50,000 in mortgage boot, which is subject to capital gains tax.
To avoid taxation, exchangers who exchange properties with unequal mortgage debt can bring additional cash to the closing table. It's important to note that while you can use cash to offset mortgage debt, you cannot use additional debt to offset any cash taken from the exchange.
Unlike cash boot, mortgage boot doesn't generate an immediate tax liability. Instead, the tax liability arises when the replacement property is sold, and the mortgage boot is realized. It's important to remember that the tax liability on mortgage boot will be based on the capital gains tax rate applicable to the taxpayer's income and filing status at the time of the sale.
It's worth noting that mortgage boot can also be created if the replacement property has no mortgage, or if the mortgage on the replacement property is larger than the mortgage on the relinquished property. In either scenario, the difference between the mortgages would be considered mortgage boot, subject to capital gains tax.
In summary, mortgage boot can be generated during a 1031 exchange when the debt on the replacement asset is less than the debt on the relinquished property. Exchangers can avoid taxation on mortgage boot by bringing additional cash to the closing table, and the tax liability on mortgage boot arises when the replacement property is sold.
In order to avoid generating mortgage or cash boot during a 1031 exchange, the entire sale proceeds from the relinquished property must be rolled over into a like-kind replacement asset, and an equal or greater amount of debt must be swapped. It's essential to avoid trading down, as this typically results in generating cash boot, debt reduction, or both, and may result in a taxable event.
If cash is taken out of the exchange, it's possible to supplement any reduction in mortgage debt during the closing on your replacement property by bringing additional cash to the table. Additionally, bringing cash to the closing table on the replacement asset can "square up" exchange funds.
To fully satisfy the equity and debt requirements on replacement properties and avoid generating cash or mortgage boot, it's recommended to consult with a Qualified Intermediary beforehand. This will help investors understand the exact amounts required to comply with exchange requirements.
In summary, investors must reinvest the entirety of the sale proceeds from their relinquished assets and swap an equal or greater amount of debt to avoid generating mortgage or cash boot during a 1031 exchange. They should also seek to trade up or straight across instead of down, and consult with a Qualified Intermediary to better understand exchange requirements and avoid taxable events.
General Disclosure
Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
Perch Financial LLC and Emerson Equity LLC do not provide legal or tax advice. Securities offered through Emerson Equity LLC Member FINRA/SIPC and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein. 1031 Risk Disclosure:
No offer to buy or sell securities is being made. Such offers may only be made to qualified accredited investors via private placement memorandum. Risks detailed in a private placement memorandum should be carefully reviewed, understood, and considered before making such an investment. Prospective strategies and products used in any tax advantaged investment planning should be reviewed independently with your tax and legal advisors. Changes to the tax code and other regulatory revisions could have a negative impact upon strategies developed and recommendations made. Past performance and/or forward-looking statements are never an assurance of future results.
Many of the investments offered will be only available to those investors meeting the definition of an Accredited Investor under SEC Rule 501(A) and offered as Regulation D private placement securities via a Private Placement Memorandum (“PPM”). Prospective investors must receive, read, and understand all the risks associated with buying private placement securities. Investments are not guaranteed or FDIC insured and risks may include but are not limited to illiquidity, no guarantee of income or guarantee that all tax advantages or objectives will be met and complete loss of principal investment could occur.
Risk Disclosure: Alternative investment products, including real estate investments, notes & debentures, hedge funds and private equity, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-U.S. exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in U.S. markets. Additionally, alternative investments often entail commodity trading, which involves substantial risk of loss.
NO OFFER OR SOLICITATION: The contents of this website: (i) do not constitute an offer of securities or a solicitation of an offer to buy of securities, and (ii) may not be relied upon in making an investment decision related to any investment offering by Perch Financial LLC, Emerson Equity LLC, or any affiliate, or partner thereof. Perch Financial LLC does not warrant the accuracy or completeness of the information contained herein.
