Recent email from a Cash On Cash reader -- "What is Boot?
Section 1031 of the Internal Revenue Service code offers an excellent opportunity for real estate investors by means of deferred tax exchanges. But investors also need to be very careful about getting into a 1031 exchange boot. If they do, they might still end up with a tax bill that they were trying to defer. Here is why. Under current IRS 1031 exchange rules, only "like-kind" property held for business or investment purposes qualifies for a 1031 exchange. There are a number of things, however, that if included as a part of the exchange, can trigger a capital gain tax bill on the portion of the exchange that they represent. These examples are called a 1031 exchange boot. A 1031 exchange boot can include any item in the trade that is not of the "like kind" as defined under section 1031 of the IRS tax code. Quite often people mistakenly get these boots included in their 1031 exchange, and they unfortunately will end up with a capital gain tax bill.
The two most common types of boots that a real estate investor come across are a Mortgage boot and Cash boot. There are also many other types of boots like personal residence boot, and personal property boot, etc.
A mortgage boot on your 1031 exchange takes place when the investment property you buy has a mortgage debt of lesser value than the mortgage debt on the property you happen to sell. It is strongly advised that the real estate property you buy should have a mortgage debt equal to, or greater than the property you are selling. In the rare case that the real estate property you buy has a lesser mortgage debt amount than the property sold, the difference in the mortgage value will be taxable to the investor.
To avoid a 1031 mortgage boot, you have two choices -- 1) If the seller of the property refinanced the property and you happen to assume the new higher debt, you are allowed to finance it through a new loan or a "land sale" contract. 2) Simply add cash to the deal and the cash added into the deal offsets the debt relief on the property sold by you.
Let's switch to a cash boot discussion. By definition any cash or other cash equivalent value received ex. (promissory note) in a 1031 exchange is also not included in the "like-kind" property and is considered as a cash boot. On any such income from capital gain taxes are applicable or if the cash amount is a composite amount of principal and interest, the capital gain taxes are always charged on the principal amount. If this cash happens to be held for a longer period and you earn any interest payment from that, those interest payments will also be taxable as regular income. Keep in mind, if the seller is paying cash for any repair charges that are required by the buyer then the amount paid by the seller towards the repair charges are considered as a cash boot and then it would also be taxable.
Thanks to "Luke" for the great question!