In order to defer ALL capital gains and depreciation recapture taxes from the sale of the Relinquished Property, the taxpayer must pay an equal or higher price for the Replacement Property than the Relinquished Property was sold. Should any debt or amount not be reinvested, this portion — called boot — would be taxable.

To fully defer all taxes, the replacement property value must equal or exceed the relinquished property sale price — with no cash left over.

What is Boot?

Boot is any non-like-kind property or properties that does not qualify, which could include cash, notes, partnership interests, securities, inventory, or property held primarily for sale (not investment). Boot is categorized in two types:

The Two Types of Boot

  • Cash Boot — Cash received from the exchange proceeds that is not reinvested into the replacement property.
  • Mortgage Boot — Any reduction in loan or debt on the exchange. If you carry less debt on the replacement property than the relinquished, the difference is considered boot.

Any boot received during a 1031 exchange is subject to taxation as either depreciation recapture or capital gain — whichever applies to your specific situation.

Settlement Statement Credits to Watch

It is important to note that any credits on the settlement statement directly paid out to the taxpayer may also result in boot and a taxable event. If certain situations are not handled properly in the construction and administration of the 1031 exchange, it can result in credits on the settlement statement.

Here are a couple of common situations that create unintended boot:

Earnest Money Paid Out of Pocket

If earnest money is paid out of pocket by the taxpayer, they will be credited on the settlement statement. To avoid this, the earnest money should be paid by the Qualified Intermediary (QI) out of the exchange funds whenever possible. This keeps all money flowing through the QI and prevents boot.

Property Tax & Proration Credits

If the settlement statement shows credits for property taxes, security deposits, or rent prorations — those amounts would be taxable. Instead, the taxpayer should consider asking the seller to pay these items outside of the closing to prevent them from appearing as settlement credits.

The Bottom Line

In summary, to avoid a taxable event entirely, the taxpayer must reinvest equal to or greater than the value of the sale of the Relinquished Property — including carrying equal or greater debt on the replacement property. However, the taxpayer may intentionally take cash out, creating boot, but they will have to pay the associated taxes on that amount.

Structuring your exchange correctly from the start is critical to avoiding unintended taxable boot. Our legal team at 1031 Ivy Exchange works closely with clients to ensure every aspect of the exchange is properly administered from day one.