Is Boot in a 1031 Exchange Taxed as a Capital Gain?

Real estate investors may already understand that money isn’t only made when a property is liquidated, or monthly rents are paid. Instead, they understand there may be tax breaks that are allowable under the federal tax code, such as 1031 exchanges. The government has put provisions in place that incentivize investing and reinvesting, but it’s up to investors to know how to pursue those provisions to benefit their personal investment business.

What Is a 1031 Exchange?

A 1031 exchange, which is also referred to as a like-kind exchange, is an option that is open to investors who sell an investment property. Upon selling one investment property, investors can use the proceeds generated by the sale to purchase another investment property that is considered to be “like-kind” to the one that they sold.

There are some misconceptions about these properties, largely surrounding the term like-kind. The federal tax code’s definition of like-kind is relatively loose, meaning that properties don’t have to be exactly alike to fall under this category. For instance, if you own an apartment complex and then sell it, you don’t have to purchase another apartment complex to be eligible to use a 1031 exchange. In fact, you don’t have to purchase a residential property at all. You can sell an apartment complex and then purchase a strip mall, and still be eligible for a 1031 exchange. However, you have to reinvest all the proceeds from the sale of your relinquished property into the replacement property. Failure to do so results in what’s called ‘boot.’

 

What Is “Boot” in a 1031 Exchange?

In order to better understand what happens when you’ve received boot in a 1031 exchange, let’s take a look at a hypothetical situation. Let’s assume that you owned an apartment complex that you sold for $250,000. You know that you have 45 days to identify a property that you want to buy, and 180 days (inclusive of the initial 45 days) to purchase a new property using those funds under the rules of a 1031 exchange. Well before that deadline expires, you find another commercial property that you want to purchase, but the asking price on it is only $200,000. Now that you’ve purchased it, you’re left with $50,000 that will be considered as boot by the federal government.

Ultimately, the federal government expects to be paid any money that they are owed, including the funds that you have left over after you complete your exchange. In this case, you’re holding $50,000 in boot, because you didn’t use all of the money to purchase a new property. Under federal tax guidelines, you will be required to claim this $50,000 as capital gains and pay taxes on it.

The requirement that you pay taxes on any unused funds at the end of a 1031 exchange is why many investors insist on only trading across or trading up after they sell a property. Trading across means that you purchase a property for the same price that you sold the previous property for, while trading up means you purchase a more expensive property. Trading down leaves you with money in your pocket that you’ll be expected to pay taxes on. The most important thing is that you operate within the framework of the law on all of your investment transactions.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. Cash flow or income are not guaranteed. Examples shown are for illustrative purposes only.

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