A Guide to Boot in 1031 Exchanges

By using a 1031 exchange, investors can defer capital gains taxes on the sale of an investment property by reinvesting in like-kind properties. However, not all exchanges are perfectly structured, and certain financial elements can create unexpected tax liabilities. One factor to be aware of is "boot," a term that frequently arises in discussions about 1031 exchanges.

Understanding boot is crucial for investors aiming to maximize tax deferral while ensuring their exchange meets IRS requirements.

What Is Boot in a 1031 Exchange?

In a 1031 exchange, the goal is to reinvest all proceeds from the sale of a property into a new like-kind investment to defer capital gains taxes. However, when part of the proceeds isn’t reinvested, that portion is known as boot, which becomes taxable.

For example, if you sell a property for $500,000 but only reinvest $400,000 in a replacement property, the remaining $100,000 is considered boot and will be subject to capital gains tax (up to the total amount of capital gains on the sale).

Where Does the Term “Boot” Come From?

The term “boot” in a 1031 exchange has its roots in an old English phrase, “to boot,” which means “something extra” or “in addition to.” Historically, this phrase was used in bartering when one party needed to add extra value to even out a trade.

In the context of a 1031 exchange, boot carries a similar meaning. It represents any additional value received in a transaction that is not like-kind property, such as cash or debt relief. Since a 1031 exchange is meant to be a tax-deferred trade of investment properties, receiving boot disrupts that balance and triggers a taxable event.

Common Types of Boot in a 1031 Exchange

Boot isn’t limited to just leftover cash; it can take other forms, which may include:

Personal-use property: A 1031 exchange is strictly for investment or business properties. If a portion of the proceeds is used to acquire property intended for personal use, it does not qualify as like-kind and will be taxed as boot.
Real property for personal property or non-qualified assets: Exchanging real estate for personal property, such as equipment, furniture, or financial assets like stocks, bonds, or partnership interests, does not meet the like-kind requirement. Any value assigned to non-qualified property in the exchange is considered boot.
Non-allowable expenses: proceeds used to cover “non-allowable” expenses during a closing will become boot.
Cash proceeds that aren’t reinvested: If any cash remains after purchasing a replacement property—whether due to a lower purchase price or a failure to reinvest all proceeds—it becomes taxable boot.
Cash received after closing: Any additional funds received from the relinquished property sale escrow after finalizing the purchase of all identified replacement property will be taxed as boot.
Funds are withdrawn before reaching a Qualified Intermediary (QI): Once the sale of a relinquished property closes, all proceeds must go directly to a Qualified Intermediary to maintain the exchange’s tax-deferred status. If the seller, or any agent for the seller, takes possession of any funds before they reach the QI, that amount becomes taxable.
Mortgage debt relief: If the debt on the replacement property is lower than the debt on the relinquished property, the difference is considered mortgage boot and may be taxable.

How Does Boot Happen in a 1031 Exchange?

Boot can arise in a 1031 exchange in several ways. Here are some of the most common scenarios where investors deal with boot:

Trade-down in value: If the value of the replacement property is lower than the relinquished property, the leftover cash from the sale becomes taxable boot. This can happen when investors fail to reinvest all proceeds or choose to take cash out of the transaction. It can also occur in situations where there is a smaller amount of financing on the replacement property than on the property sold.
Mortgage reduction: If the mortgage on the replacement property is smaller than the mortgage on the relinquished property, the difference—known as mortgage boot—may be taxable. Even though no cash is received, the IRS views this debt reduction as a financial gain. Taxpayers can avoid this by reinvesting all proceeds from the sale of their property, and by investing cash or a new loan equal or greater to the loan on the relinquished property.
Non-allowable transaction costs: Using exchange funds to pay for non-qualified expenses, such as insurance premiums, pro-rated rents, or financing costs, results in boot. These costs do not count toward the like-kind reinvestment requirement, making that portion of the proceeds taxable.
Non-like-kind property: If an investor receives anything other than real estate—such as furniture, equipment, or a vehicle—as part of the exchange, it is considered boot. Real estate that is not investment property, or “like-kind” to the property sold, such as a personal residence, would also create a boot event if acquired with exchange proceeds.

How Do You Calculate Boot?

Calculating boot in a 1031 exchange helps investors anticipate potential tax liabilities and determine whether keeping some proceeds or reducing debt is worth the tax consequences. While the calculation can be tedious, understanding it beforehand can prevent surprises during and after the transaction. Boot is determined by comparing the financial details of both the sale and purchase sides of the exchange.

Sale-Side Considerations When Calculating Boot:

To determine potential boot, start by evaluating the closing figures for the relinquished property:

Sales price: The total amount the property is sold for before any credits or costs.
Adjusted basis: The original purchase price, plus improvements, minus depreciation taken during ownership.
Liabilities owed: Any mortgage or debt tied to the relinquished property that must be paid off at closing.
Commissions and closing costs: Fees and transactional costs like commission or transfer taxes that reduce the net proceeds of the sale.

Purchase-Side Considerations When Calculating Boot:

Next, analyze the purchase figures for the replacement property:

Purchase price: The total amount paid for the new property
New mortgage or liabilities: The amount of debt taken on with the new property
Commissions and closing costs: Fees and costs associated with acquiring the new property
Other transaction costs: Expenses directly related to the exchange, such as legal and title fees
Cash needed to close: How much cash, taking into account the above figures, is needed from the exchange account?

If there is a difference between the net cash received from the sale after all costs and liabilities, and the cash reinvested into the replacement property, that amount is considered boot and will be subject to taxation (up to the total amount of capital gains). Similarly, if the mortgage on the replacement property is lower than the mortgage on the relinquished property, the difference is also classified as boot, unless the investor includes additional outside cash to the closing so that the total value of new loan and/or outside cash invested equals the value of the debt on the relinquished property.

Examples of Boot in a 1031 Exchange

When learning about boot in a 1031 exchange, it can be helpful to look at some real-world examples.

Mortgage Boot

Let's say you have an investment property with a basis of $1,000,000 and a $500,000 sales price, and an outstanding mortgage balance of $300,000. As part of a 1031 exchange, you plan to reinvest in a replacement property.

You find a new property but decide to purchase one valued at $450,000 with a mortgage of $250,000. All cash will be reinvested. However, because the new loan amount ($250,000) is $50,000 less than the mortgage on your relinquished property ($300,000), this $50,000 difference is considered mortgage boot.

Even though you did not receive cash from the transaction, the IRS views this debt relief as financial gain, meaning you'll owe capital gains taxes on the $50,000 mortgage boot. You would have successfully deferred the other $50,000 of gain.

Cash Boot

Imagine you're an investor who owns a rental property purchased for $200,000 that you sell for $600,000 as part of a 1031 exchange. After paying off the existing mortgage of $200,000, you have $400,000 in net proceeds available for reinvestment.

You identify a replacement property worth $350,000 with a new loan of $200,000 and $150,000 of the exchange funds. The debt value has been offset with an equal value new loan; however, because you’re not reinvesting the remaining $250,000 of proceeds into the new property, that $250,000 is considered cash boot. This means that you would need to pay capital gains taxes on the $250,000 you retained from the transaction, having deferred the other $150,000 of the total $400,000 of gain.

How Is Boot Taxed in a 1031 Exchange?

When boot is received in a 1031 exchange, it is subject to taxation because it represents a portion of the proceeds that were not reinvested in a like-kind property. The specific tax treatment depends on the type of boot received and the investor’s individual tax situation. However, in all cases, investors are only taxed on their boot up to their total amount of capital gains. In other words, if their boot exceeds their capital gains, they’d only be taxed on the portion of the boot equal to their capital gains.

Tax Treatment of Cash and Mortgage Boot

Cash and mortgage boot is taxed as a capital gain. The rate depends on how long the relinquished property was held:

Short-term capital gains: If the property was held for one year or less, the boot is taxed as a short-term capital gain at ordinary income rates.
Long-term capital gains: If the property was held for more than a year, the boot is taxed at long-term capital gains rates, which are generally lower than ordinary income rates.

Tax Treatment of Non-Like-Kind Property

If an investor receives non-like-kind property using exchange proceeds, such as personal property or other assets, its fair market value is taxed as boot. This can include items such as vehicles, equipment, or furniture included in the transaction.

Because boot results in a partially (or sometimes fully) taxable exchange rather than a fully tax-deferred one, it’s important for investors to calculate potential boot in advance. Consulting a tax professional can help minimize tax liability and ensure the exchange is structured as efficiently as possible.

How Can You Avoid Boot in a 1031 Exchange?

Avoiding boot in a 1031 exchange requires careful planning to ensure that all proceeds are reinvested into like-kind property and that no unintended taxable gains occur. By structuring the exchange correctly, investors can maximize their tax deferral and avoid unnecessary liabilities.

Here are some key strategies to prevent boot:

Reinvest All Proceeds into a Like-Kind Property

To fully defer taxes, the purchase price of the replacement property should be equal to or greater than the sales price of the relinquished property. Any leftover cash from the transaction becomes taxable boot, so it’s essential to reinvest the full amount.

Match or Increase the Mortgage Amount

If the new property has a lower mortgage balance than the relinquished property, the difference (mortgage boot) is taxable. To avoid this, investors should either take on equal or greater debt in the replacement property or contribute additional cash to offset the mortgage reduction.

Work with a Qualified Intermediary

A QI is required in a 1031 exchange to facilitate the transaction and ensure compliance with IRS rules. If the investor takes possession of any sale proceeds before they are reinvested, that amount becomes taxable boot. A QI holds the funds and transfers them directly to the replacement property's seller, preventing accidental receipt of cash.

Avoid Receiving Non-Like-Kind Property

Receiving assets such as personal property, stocks, or other non-qualified items as part of the exchange results in taxable boot. Ensuring that the entire transaction consists of real estate helps maintain full tax deferral.

Plan for Transaction Costs

Certain costs, such as broker commissions, escrow fees, and owner’s title insurance, can be paid with exchange funds without creating boot. However, using proceeds for non-qualified expenses—like loan fees, repairs, or personal withdrawals—can generate taxable boot. Understanding which costs qualify can help investors structure the deal properly.

The Final Word on Boot

Successfully navigating a 1031 exchange requires careful planning to avoid unintended tax consequences, and understanding boot is a key part of that process. While boot doesn’t necessarily invalidate an exchange, it can trigger taxable gains that reduce the overall benefits of the transaction. By structuring deals strategically, working with qualified professionals, and being mindful of how cash, debt, and property values factor into the exchange, investors can minimize or eliminate boot altogether. With the right approach, a 1031 exchange can remain a powerful tool for deferring taxes and building long-term wealth through real estate investments.

Interested in using a 1031 exchange to defer capital gains tax? Contact the experts at First American Exchange Company today.