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"Boot" and Expenses
Bob Calongne • October 2, 2019
Non-allowable expenses paid in a 1031 exchange
Non-allowable expenses paid out of sale proceeds are taxable boot (like cash taken by Exchanger/Seller), however, if you pay them personally (outside of closing) it will not be taxable boot.
And if non-allowable expenses of Buyer/Exchanger are credited to buyer at purchase of replacement property then that is also cash boot.
Boot is any non like-kind payment received as part of an exchange. Boot is categorized as either "debt reduction" or "mortgage" boot or "cash" boot. Mortgage boot is made up of liabilities assumed in the exchange. (For example, if your mortgage is paid off, you have "received" boot; if you assume another party's mortgage, you "pay" boot.) Cash boot is cash or other non like-kind property. Relief of debt is a taxable event.
Taxes may be due if the you place more debt on the replacement property than there was on your relinquished property. If the increased debt results in excess proceeds because you did not use all of the funds held by the QI, you will receive taxable boot.
EXCHANGE EXPENSES
Certain expenses paid at a closing are considered allowable "exchange expenses” and using exchange funds to pay those expenses will not result in any tax liability to an investor doing a 1031 exchange.
Other expenses are not exchange expenses (non-allowable), so although exchange funds may be used to pay the expense, doing so results in the exchange being partially taxable.
ALLOWABLE EXCHANGE EXPENSES and CLOSING COSTS
Certain expenses paid at a closing are considered allowable “exchange expenses” and using exchange funds to pay those expenses will not result in any tax liability to an investor doing a 1031 exchange. For example, Internal Revenue Ruling 72-456 provides that if exchange funds are used to pay broker’s commissions, it does not result in the transaction being partially taxable.
There are no other clear rulings on this subject, but most tax advisors agree that the following expenses are allowable exchange expenses and may be paid at the closing of the relinquished or replacement properties without any tax consequence:
Broker’s commissions Exchange fees Title insurance fees for the owner’s policy of title insurance Escrow fees Appraisal fees required by the purchase contract Transfer taxes Recording fees Attorney’s fees incurred in connection with the sale or purchase of the property
NON-ALLOWABLE EXCHANGE EXPENSES
Other expenses are non-allowable exchange expenses, so although exchange funds can be used to pay the expense, doing so results in the exchange being partially taxable. For example, security deposits and prorated rents are not considered exchange expenses and if exchange funds are used to pay them, the exchange will be partially taxable. This comes up when the seller of the relinquished property gives the buyer a credit at the closing for the security deposits and prorated rents. The result of the credit is as if the seller was using exchange funds to pay the security deposit and prorated rent amounts to the buyer. To avoid the tax, the seller should deposit his own funds to pay those security deposits and prorated rents to the buyer.
In addition, most tax advisors believe that fees and costs in connection with getting the loan to acquire the replacement property are costs of the loan, not costs of purchasing the replacement property, and therefore under tax law are not allowable exchange expenses. If you use exchange funds at the closing of the replacement property to pay loan costs and fees, it is likely that doing so will create a tax liability. To avoid the tax liability, the buyer may want to deposit his own funds to pay any loan related expenses.
Some non-allowable exchange expenses create a tax liability but are offset by a deduction. One example of this is property taxes. Although property taxes are not an allowable exchange expense, you will get a deduction for paying the property taxes and so the liability will be offset by the deduction.
The following is a list of expenses that are typically found on a closing statement but are generally not considered allowable exchange expenses:
• Loan costs and fees• Title insurance fees for lender’s title insurance policy• Appraisal and environmental investigation costs that are required by the lender• Security deposits• Prorated rents• Insurance premiums• Property taxes
Using exchange funds to pay non-allowable expenses should not disqualify an exchange but it may create taxable boot. You can choose to either come up with your own funds to pay these expenses if you can to avoid boot, or give the buyer a credit at the closing, in which case it will be partially taxable.
It is always a good idea to have your tax advisor review the numbers on the closing statement prior to closing. That will ensure that you have a good idea of the net proceeds you will be working with when buying replacement property and whether you will have a fully tax-deferred exchange.
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Consult with your tax or legal advisor about your specific case.
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The 1031 Exchange Center Tips
Are you a real estate investor looking for ways to optimize your tax position while expanding your property portfolio? One powerful strategy at your disposal is the partial exchange transaction, a key component of a broader concept known as a tax-deferred exchange in real estate. We as an intermediary in this field, will delve into the world of partial exchange transactions, shedding light on how they can benefit your real estate investments. Understanding the concept A partial exchange," is a subset of a tax-deferred exchange in real estate , particularly under Section 1031 of the Internal Revenue Code. The primary goal of a partial exchange is to allow investors to defer capital gains taxes when exchanging one property for another. What sets it apart is that it permits investors to receive some cash or non-like-kind property (referred to as "boot") in addition to the like-kind property they acquire. How Does a Partial Exchange Work? A partial exchange follows a structured process: Identification of Properties: Just like a standard 1031 exchange, the process begins with the identification of the relinquished property (the property you're selling) and the replacement property (the property you're acquiring). This step is critical to the success of the exchange. Boot Consideration: In a partial exchange, investors may receive cash or non-like-kind property, referred to as boot, in addition to the like-kind property they acquire. The amount of boot received is taxable. Investors must decide how much boot they are willing to receive based on their tax strategy. Tax Deferral: The primary objective of a partial exchange is to defer capital gains taxes on the sale of the relinquished property by investing in like-kind property of equal or greater value, even if they choose to receive some boot. Benefits of a Partial Exchange Tax Savings: By using the partial exchange strategy, investors can defer capital gains taxes and allocate them towards the acquisition of a more valuable like-kind property. Enhanced Flexibility: The partial exchange allows investors to retain a portion of the sale proceeds in cash or non-like-kind property, offering greater flexibility in managing their financial resources. Strategic Investments: Investors can strategically choose properties that align with their investment objectives, even if it means receiving some boot in the transaction. Property Diversification: Diversification can be achieved by retaining some boot to invest in non-like-kind properties that complement their real estate portfolio. Key Considerations Investors considering this kind of tax-deferred exchange in real estate should keep the following considerations in mind: Tax Implications of Boot: While boot can provide flexibility, it's important to understand the tax implications of receiving it, as it may be subject to capital gains taxes. Identifying Replacement Property: Identifying suitable replacement properties within the IRS's strict timeframes is crucial to the success of a partial exchange. Qualified Intermediary: Working with a qualified intermediary like us is essential to ensure that the exchange complies with IRS regulations and guidelines. In conclusion, A partial exchange transaction is a valuable tool for real estate investors aiming to defer capital gains taxes while enjoying flexibility in managing their financial resources. By understanding how this strategy works and its associated benefits and considerations, investors can make informed decisions that align with their investment goals. When used diligently with the help of an intermediary like us, the 1031 Exchange Center, LLC a partial exchange can enhance your real estate investment journey and contribute to your long-term financial success. Contact us today to speak with our experts and get started on your path to tax savings and financial flexibility in your property portfolio. We're here to guide you through the process and help you make the most of your investments.
Are you a real estate investor looking to maximize gains while minimizing tax liabilities? If so, you've likely heard of a construction exchange 1031 , a powerful tool within the world of real estate transactions. As a qualified intermediary in 1031 exchange, we will attempt to explore the fundamentals of this strategy and how it can help you defer taxes through a deferred exchange while focusing on the construction 1031 exchange aspect.
A tax-deferred exchange does not mean you'll have to eventually pay the tax
The 1031 Exchange Center LLC is an IRS Qualified Intermediary that is not permitted to give legal or tax advice. Please consult with your legal or tax advisors concerning your specific case. But for a complimentary confidential evaluation, please click the button below.