Boot: cash, debt relief and the equity rule

What counts as boot

Section 1031(b) governs any exchange where the exchanger receives money or other non-like-kind property along with the replacement real estate. In that situation, gain is recognized, but only up to the lesser of the boot received or the total gain realized on the sale. Boot never creates more tax than the transaction would have produced outside an exchange, and it never creates tax where there was no gain to begin with.

Boot takes two common forms in a real estate exchange: cash boot and mortgage boot. Both are measured separately and then combined for tax purposes.

Cash boot

Cash boot is any money the exchanger ends up with instead of replacement property. It commonly includes cash taken at the sale closing, cash left in the exchange account once the purchase closes and the exchange period ends, seller credits paid to the exchanger rather than applied to the transaction, and non-qualifying costs paid out of exchange funds. A seller credit that reduces what the exchanger pays but is not itself an expense of the sale or the exchange functions the same way as cash received.

Mortgage boot and debt relief

Under section 1031(d) and Treas. Reg. §1.1031(d)-2, a liability assumed by the buyer, or a liability the exchanger is otherwise relieved of at the sale, is treated as money received by the exchanger for purposes of computing gain and boot. If the exchanger pays off a $400,000 mortgage at the sale and takes on only $350,000 of new debt on the replacement property, the $50,000 difference is treated the same as if the exchanger had walked away with $50,000 in cash.

Liabilities on the relinquished side and liabilities on the replacement side are netted against each other rather than treated as two separate boot items. New debt taken on the replacement property, or additional cash the exchanger contributes at that closing, offsets debt relief. The netting runs one way only: cash actually received by the exchanger cannot be offset by taking on more debt elsewhere in the transaction. Debt relief can be cured with cash or new debt; cash received cannot be cured with debt.

The two rules for full deferral

To defer the entire gain, an exchange needs to satisfy two conditions at once. First, the replacement property must be purchased for value equal to or greater than the property sold, net of selling costs. Second, all of the net equity from the sale must be reinvested, and any debt paid off at the sale must be matched by new debt on the replacement property, additional cash contributed by the exchanger, or some combination of the two. Falling short on either condition produces boot equal to the shortfall.

A worked example

An exchanger sells relinquished property for $1,000,000 with a $400,000 mortgage, then buys replacement property for $900,000 with a $350,000 mortgage.

Trade-down and debt relief on a $1,000,000 sale

Item	Relinquished property	Replacement property
Sale or purchase price	$1,000,000	$900,000
Mortgage	$400,000 paid off	$350,000 new
Net equity	$600,000	$550,000 required

The replacement is $100,000 less than the property sold, so there is a $100,000 trade-down. Of that shortfall, $50,000 is debt relief: the new mortgage is $50,000 lower than the mortgage paid off, and no additional cash was contributed to offset it. The remaining $50,000 is equity the exchanger did not reinvest, cash boot in substance even if it never physically changes hands at closing. Total boot is $100,000, which equals the trade-down; the two figures describe the same shortfall from different angles rather than adding on top of each other. Whatever the total realized gain on the sale turns out to be, recognized gain is the smaller of that gain or the $100,000 of boot. The exchange calculator works through a given set of numbers.

Partial exchanges are still exchanges

Taking boot on purpose is a legitimate strategy. An exchanger who wants some liquidity can buy less than full value or take cash out, pay tax on that portion, and still defer the rest. The reinvested balance is treated exactly as it would be in a fully deferred exchange; only the boot portion is currently taxable.

How boot is taxed

Boot is taxed as gain, in the same order gain would be taxed on a fully taxable sale. Recognized gain is generally characterized as unrecaptured section 1250 gain to the extent of prior depreciation before the balance is treated as long-term capital gain; your tax advisor confirms the characterization. See depreciation recapture in an exchange for how that ordering works and what the rates are.

Transactional costs: what can be paid from exchange funds

Treas. Reg. §1.1031(k)-1(g)(7) lets certain transactional items (for example commissions, prorated taxes, transfer taxes and title company fees) be handled at closing without breaking the qualified intermediary safe harbor. Whether a given cost reduces gain or is treated as boot is a separate question for the tax advisor. Items commonly treated as exchange expenses that can be paid from exchange funds without creating boot include real estate commissions, title insurance and closing fees, transfer taxes, and the qualified intermediary's own fee. Items commonly treated differently, because they relate to financing or to the operation of the property rather than to the transaction of sale, include prorated rent credited to the buyer, transferred security deposits, and loan origination or other financing costs on the replacement purchase. Paying those from exchange funds is generally treated as boot. Because much of this distinction rests on guidance rather than a single bright-line statute, an exchanger with a closing statement full of miscellaneous line items should have it reviewed before the closing, not after.

Reporting boot on Form 8824

Boot, along with realized gain, recognized gain and the resulting basis, is reported on Form 8824 with the return for the year the relinquished property was sold. Form 8824 reports cash, other property and net debt relief together on line 15, after the netting described above.

Sources

• Internal Revenue Code §1031(b) and (d).
• Treas. Reg. §1.1031(d)-2 (treatment of liabilities); §1.1031(k)-1(g)(6) and (g)(7) (constructive receipt exceptions; transactional items).
• IRC §1250 and §1(h) (unrecaptured section 1250 gain).
• IRS Form 8824 and instructions.