Samuel’s case –
Samuel, a 56-year-old full-time investor, was looking to sell an investment property and purchase a new one. Surely, Samuel wanted to defer capital gains tax using a 1031 exchange. However, he wanted to save a bit of cash from the sale of the relinquished property. For a long, he kept wondering if he could do both? Thankfully, Samuel consulted a 1031 exchange expert.
The very notion associated with a 1031 exchange is that you cannot keep the cash no matter what. Otherwise, the IRS can put the 1031 exchange to question. This is what investors fear the most. Undoubtedly, you cannot keep the cash if you want to defer 100% capital gains tax after the sale of your investment property. However, if you choose to pay a portion of your capital gains tax, you will be able to keep a part of your proceeds.
However, things could change just that as they did in Samuel’s case. Talking to a 1031 exchange expert can help you find ways to complete your 1031 exchange without getting penalized by the IRS.
If you save some money at the end of your exchange, it results in a boot.
In simple words, ‘Boot’ is defined as anything given ‘in addition to.’ When it comes to 1031 exchanges, the boot is usually the cash or the money saved at the end of an exchange. Still, sounds confusing? Let’s learn this through an example. Say you sold your investment property for $500K.
However, the property you chose as the replacement for your relinquished property costs $400K. If you proceed with the same property, you will save $100K at the end of your exchange. As the IRS requires you to acquire a property of the same value as the relinquished property, this can jeopardize your 1031 exchange, and you might not be able to defer your capital gains taxes.
If you want to do a 1031 exchange, you may want to dodge any boot during the transaction. In a 1031 exchange, the boot is generally referred to as the money saved by the investor in the exchange. However, you don’t get a boot only in the form of cash.
Boot can result in any of the following forms –
- Cash – Cash boot is the amount received by an investor after the completion of a 1031 exchange. For example, if your old property costs more than your new property, you will have to pay taxes on the difference in value.
- Debt Reduction – When the loan on the new property is less than the debt on the old property, it’s called debt deduction.
- Sale Proceeds – If you take out a part of your 1031 proceeds and invest in non-qualified expenses like utility bills or escrow agent’s fees, you will have to pay taxes on the money invested.
Well, it could be heartbreaking, but cash boot determined at the end of a 1031 exchange immediately disqualifies the same. To ensure that no change occurs in an investor’s previous investment, the IRS requires them to reinvest the entire proceeds from the relinquished property sale. Suppose any investor violates this law and withdraws any amount from the sale proceeds. In that case, the IRS penalizes that 1031 exchange by imposing capital gains tax on the entire transaction or the saved amount.
There is a hack.
Believe it or not, you can save your 1031 exchange and still withdraw a part of your sale proceeds. A partial 1031 exchange can make it possible.
How to avoid boot?
The best way to avoid cash boot and save a 1031 exchange is to invest the remaining amount in a DST. A DST or Delaware Statutory Trust is a legal entity that owns, manages, and sells investment-grade properties. DST shares qualify as 1031 exchange replacement options. By investing the saved amount in a DST, you will be able to distribute your entire sale proceeds into two new properties (replacement property+DST property). This way, you can avoid boot and save your 1031 exchange.
There are other ways too.
What if you don’t want to invest in a DST? Well, there are other ways using which you can avoid cash boot and keep your 1031 exchange running. You can invest in net leased or triple net properties to compensate for the boot.
What most investors often find challenging is, managing their investment properties. When you lease your investment property to a tenant, you are responsible for paying all operating expenses associated with that property. The tenant pays a flat rent, and you bear all operating expenses. Plus, you also need to make sure that the bills are being paid timely to avoid late charges. Investors often find this responsibility annoying. This is where a NNN lease proves to be an effective investment strategy.
For a successful 1031 exchange, it’s recommended you speak to your tax advisor or a 1031 expert.