1031 Exchange Boot
While section 1031 of the IRS offers
excellent opportunity for the real estate investors
by means of deferred tax exchange, the investors need
to be careful about getting a 1031 exchange boot with
which they might still end up with a tax bill.
Under the 1031 exchange rules, only
like-kind property held for business qualifies for a
1031 exchange. Now, there are a number of things 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 are called 1031 exchange
boot.
1031 exchange boot includes any item
included in the trade that is not of like kind as defined
under section 1031 of the IRS. Quiet often people get
these boots included in their 1031 exchange and ends
up with a capital gain tax bill for themselves.
The most common types of boot that
real estate investors come across are :
a) Mortgage boot
b) Cash boot
There are also various other
types of boots like personal property boot, personal
residence boot etc.
Mortgage Boot: You
get a mortgage boot on your 1031 exchange when the property
you buy has a mortgage debt of lesser value than the
mortgage debt on the property you are selling.
It is advised that the property you
buy should have a mortgage debt equal to or greater
than the property you are selling. In case the property
you buy has lesser mortgage debt amount than the property
sold in the 1031 exchange, the difference in the mortgage
value will be taxable to you.
Avoid 1031 Exchange Boot –
Way Around Mortgage Boot
- If the seller of the property refinance
the property and you assume the new higher debt. Alternatively,
you can finance it through a new loan or a land-sale
contract.
- You can add cash to the deal.
Cash Added in offsets the debt relief on the property
sold by you. Your 1031 exchange intermediary can advice
you on this.
Cash Boot: Any
cash or other cash equivalent value received (e.g. promissory
note) in a 1031 exchange is also not included in like
kind property and is considered as a cash boot. On any
such income capital gain taxes are applicable and if
the cash amount is a composite amount of any principal
and interest, the capital gain taxes are charged on
the principal amount. If this cash is retained for a
longer period and you earn any interest from that, those
interests will also be taxable as regular income.
Also, if the seller is paying cash
for any repair charges that are required by the buyer
then the amount paid by the seller towards repair charges
is considered as a cash boot and is taxable.
Your 1031 exchange
intermediary can advice you on how to avoid this type
of 1031 exchange boot.
Personal Property Boot: Often
an investment property would include appliances such
a s washers. Dryers, refrigerators etc and if these
items are included in the sale you can land up paying
capital gain taxes for them. These are not like kind
property.
These can very easily be avoided
by clearly stating in the deed that appliances are not
a part of the sale and you can always create a separate
sale agreement for the appliances for one dollar. You
can hide the actual price of the personal property (Appliances)
in the sale agreement. You should ensure that these
appliances are not included as a part of the real estate
sale.
Personal Residence Boot:
Investment property and personal
residence property are not considered as like kind property.
So if you are buying a four plex as a part of a 1031
exchange and then use one of the units as your personal
residence then one quarter of the property would be
considered as 1031 exchange boot and you will have to
pay tax on that.
You can avoid this by waiting
for the 1031 exchange to be completed and till the time
you have paid the taxes for that year and after that
you can move in to your new personal residence.
Dealer Property and Rental
Property: Dealer property
and rental property are not like kind property under
section 1031 of the IRS. A dealer property is considered
as an inventory where as a rental property is considered
as an investment. If you are doing a 1031 exchange for
a dealer property, it will not be a problem but the
problem arises when you are disposing off a dealer property
under section 1031.
Dealer property being legally
termed as an inventory is not fit for an exchange. Though
this type of exchanges take place, the IRS may always
detect these under a close audit and in that case you
will have to pay for taxes as well as penalties on the
sale of the dealer property.
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