Most common questions which investors pose are around debt and cash requirements in exchange.
“Can I draw some cash out of my exchange proceeds of the deal to pay off a debt or to purchase a car?”
Or many exchangers aren’t aware initially that to defer all capital gains, after using the sales proceeds to pay off their relinquished property’s mortgage, they’re needed to replace it with a loan of equal or more amount. Any cash removed or debt not repaid is referred to as “boot.” Let us understand boot in detail to ensure that you make informed decisions while identifying the replacement property and deciding on what to do with sales proceeds.
Equity And Mortgage Boot Basics
An essential 1031 exchange guidelines state that equity and debt for the replacement property in use must be equal to or greater than the said equity and debt in the original property. Net equity on a settlement statement (or cash due on the seller) follows from the gross selling price minus paid off debt, selling expenses, closing costs, and sales commissions.
If you do not purchase a replacement property of at least the same net equity value, you will end up paying taxes on the gain. The difference is called “boot,” a privilege that sellers receive either in equity or cash or as a reduction in debt or a mortgage boot. It’s crucial to understand that additional cash can offset debt here; however, additional debt doesn’t offset cash.
Using a basic model, let’s consider you are trading property for $200,000, less debt of $50,000 and selling expenses of $15,000. This leaves you with net equity of $135,000 – this plus your debt amount ($50,000) combine to dictate that a replacement property worth at least $185,000 must be acquired to avoid any taxable boot. Any cash you don’t re-invest will be taxable. The balance of $50,000+ must either be by way of a mortgage – or additional, outside cash may be invested to offset some (or all) of the debt requirement.
In case debt or net equity is not replaced with the new property, it’s desirable to use a partial 1031 exchange. However, when the replacement reaches a point where it’s at 50 percent of the net selling price of the original property, tax paid on the boot might equal taxes triggered without an exchange. Speak to our advisors and your CPA, whether a partial exchange suits your needs.
For more on how a boot might be used in a 1031 exchange, either via cash proceeds or a reduction in debt or a mortgage, speak to our advisors at 888-993-2835 or email us at firstname.lastname@example.org.