1031 Exchange:
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CITY 1031 EXCHANGE GUIDE |
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MESSAGE FROM BROKER/TOC
A. 1031 EXCHANGE BASICS
B. PASSING THE "PURPOSE"
TEST
C. LET'S TALK ABOUT BOOT
D. SOME ADVANCED 1031 TOPICS
LET'S TALK ABOUT BOOT
1. What on Earth is
“Boot”?
One of the most confusing concepts associated with Section
1031 exchange transactions is the concept of “boot”.
The phrase “boot” does not appear in the Internal Revenue
Code or the related regulations. The phrase is often thrown around
as if it were a simple concept. In its application, the concept
of “boot” is not simple and concrete – it is often
quite amorphous.
- “Boot” as a General
Concept. Generally speaking, “boot”
is a phrase used to describe the situation where an investor sells
the relinquished property, receives some replacement property
that qualifies under Section 1031, but then also receives something
“extra” (the “boot”) that does not qualify
as replacement property under Section 1031.
- Easy Examples of “Boot”.
Some common types of “boot” are relatively concrete
in concept, such as where the taxpayer sells the relinquished
real property, obtains some qualifying replacement real property,
but then also receives any of these:
(a) Cash;
(b) Personal property (e.g. furnishings that come along with
a hotel);
(c) Other property of a type expressly excluded from the provisions
of Section 1031 (e.g. stocks, bonds, notes, partnership or
LLC interests).
(d) Real estate that doesn’t qualify for Section 1031
(e.g. a personal residence).
- Mortgage “Boot”.
It is also possible for a taxpayer to receive relief from indebtedness
as part of an exchange transaction. This type of “boot”
is more difficult to grasp because it is hard to think of this
as a concrete object (like cash or stock). Yet, relief from indebtedness
is one of the most common types of “boot” involved
in Section 1031 exchange transactions, and one that causes a lot
of confusion for taxpayers (and their advisors). “Mortgage
boot” is potentially involved in an exchange whenever the
property to be relinquished is burdened by a secured debt. Attorneys
and accountants who regularly get involved with Section 1031 exchange
transactions are often approached by clients who express a desire
to simply reinvest their “equity” into a replacement
property without incurring any related debt. Some investors have
negative feelings toward “debt” and express an understandable
desire to structure their future real estate investments as “debt-free”
or “paid for” real estate. Unfortunately, most tax
advisors believe that, in order to comply with Section 1031 requirements
and receive full non-recognition treatment, it is necessary to
not only reinvest all equity but also offset the “mortgage
boot” received in the transaction. The most common method
used to “offset” mortgage boot is to burden the replacement
property with an amount of debt that is equal to or greater than
the amount of debt associated with the relinquished property.
Mortgage boot can also be “offset” by the infusion
of additional cash from the taxpayer (i.e. cash other than the
1031 exchange proceeds). It should be noted that there are other,
but much less common, methods for offsetting “mortgage boot”
which are outside the scope of this guide.
- Unrelated Expenses “Boot”.
A taxpayer receives boot when transaction costs not related to
the exchange are paid with the 1031 exchange proceeds (generally,
you cannot use 1031 exchange proceeds to pay loan origination
fees and related loan costs associated with a new loan used to
acquire replacement property).
2. Can “Boot”
Poison My 1031 Exchange?
The receipt of “boot” does not poison the transaction
in its entirety and a taxpayer does not recognize gain to the extent
that qualifying replacement property is acquired. To the extent
that a taxpayer receives “boot” instead of qualifying
replacement property, the taxpayer is required to recognize gain
to that extent only. The IRS regulations set forth a relatively
complex formula for partially recognizing gain in a situation where
“boot” is involved.
3. What is the
Difference Between a “Fully Deferred” Exchange and a
“Partially Deferred” Exchange?
- “Fully Deferred” Exchange.
Simply stated, a “fully deferred” exchange occurs
when the taxpayer acquires sufficient replacement property and
either does not receive any “boot” or succeeds in
properly offsetting all “boot” received. In a “fully
deferred” exchange, the taxpayer achieves complete non-recognition
of gain in connection with the sale of the relinquished property.
- “Partially Deferred”
Exchange. Some taxpayers may elect to only re-invest
a portion of their net proceeds from the sale of the relinquished
property (or elect not to “offset” all of the “mortgage
boot” received in the sale of the relinquished property),
resulting in the receipt of “boot”. Therefore, a portion
of the gain associated with the sale of the relinquished property
must be recognized.
4. Why Might I Not
Pursue a “Fully Deferred” Exchange?
The decision as to whether to pursue a fully deferred exchange,
a partially deferred exchange, or no exchange at all is influenced
by diverse and subjective factors. Some factors may include the
following.
- Immediate Cash Needs.
In some cases, a “partially deferred” exchange may
yield the best result for an investor that wants to reinvest in
some replacement property, but also obtain some cash to meet immediate
cash needs.
- Analysis of Historic Tax Rates.
A partially deferred exchange (or a sale without any exchange)
may be selected by an investor who believes that the applicable
tax rate on capital gains will be rising in future years. However,
where an investor has owned improved real estate and has taken
depreciation deductions, he or she will need to examine the impact
of both capital gains taxes and “recapture” taxes.
- Analysis of Property Values.
A partially deferred exchange (or a sale without any exchange)
may also be advisable for an investor who believes that most potential
replacement properties are over-priced, such that the benefits
of tax deferral are outweighed by the prospect of a bad investment
decision.
- Non-Real Estate Investment
Opportunities. A fantastic return on investment
may be available to a particular investor with respect to a non-real
estate investment. Such a return on investment may be substantially
more valuable to the investor as compared to the tax deferral
benefit associated with a Section 1031 exchange.
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