Boot in a 1031 Exchange: How Cash and Mortgage Relief Turn a Tax-Free Exchange Into a Taxable One

Investors talk about 1031 exchanges as tax-free. They are tax-deferred, and only fully deferred if the deal is structured right. The most common way exchanges leak tax is boot: cash or debt relief you walk away with that is not like-kind property.

Boot does not kill the exchange. It makes part of it taxable. Understanding how it is measured is the difference between a planned result and a surprise on Form 8824.

The rule

IRC 1031(b) says that if an exchange would qualify except that you also received money or other property, gain is recognized, but not more than the sum of the money and the fair market value of the other property. IRC 1031(c) adds that no loss is recognized in that situation.

Two consequences follow. Boot can never make you recognize more gain than you actually realized. And boot never creates a deductible loss.

Type one: cash boot

Cash boot is any money you receive or are treated as receiving. Common sources:

• Exchange proceeds left with the qualified intermediary after you buy the replacement property, then returned to you
• Proceeds paid to you at the closing of the relinquished property
• Seller credits on the replacement purchase that come back to you in cash
• Proceeds used to pay items that are not transaction costs, such as security deposits transferred, prorated rents credited to the buyer, or personal debts

Cash boot is the easiest to avoid. Reinvest all of the net proceeds and do not let the intermediary send you anything until the exchange is complete. Under the safe harbors in Treas. Reg. 1.1031(k)-1(g), your rights to the funds held by an intermediary must be limited; touching the money early can create constructive receipt of the entire balance, not just boot.

Type two: mortgage boot

IRC 1031(d) treats a liability of yours that another party assumes as money you received. When you sell the relinquished property and the buyer's payment retires your mortgage, you are relieved of that debt. Relief is boot unless offset.

Treas. Reg. 1.1031(d)-2 provides the netting rules, and its examples are worth memorizing:

• Liabilities you take on, or property you receive subject to liabilities, offset liabilities you are relieved of.
• Cash or other property you give also offsets liabilities you are relieved of.
• Liabilities you take on do not offset cash you receive.

That last rule is the trap. You cannot take cash out of an exchange and cure it by borrowing more on the replacement property.

Worked examples

All three examples use the same relinquished property: a Manatee County duplex worth $600,000, with a $250,000 mortgage and an adjusted basis of $300,000. Realized gain is $300,000. The numbers are illustrations.

Scenario	Replacement property	Boot	Recognized gain
A. Trade across	$600,000, new $250,000 mortgage, all $350,000 equity reinvested	None after netting	$0
B. Trade down on debt	$500,000, new $150,000 mortgage, $350,000 equity reinvested	$100,000 net debt relief	$100,000
C. Cash out and borrow	$600,000, new $300,000 mortgage, $300,000 equity reinvested, $50,000 cash to you	$50,000 cash	$50,000

In scenario B, you were relieved of $250,000 of debt and took on $150,000. Net liability relief is $100,000, which is boot. You could have avoided it by adding $100,000 of cash to the purchase, because cash paid offsets liability relief.

In scenario C, you took on $50,000 more debt than you were relieved of, but you also received $50,000 in cash. The extra debt does not offset the cash. The $50,000 is recognized.

Transaction costs

Exchange expenses such as brokerage commissions, qualified intermediary fees, and title charges paid from exchange funds are generally treated as reducing the amount realized or increasing basis rather than as boot. Non-transaction items paid from exchange funds, such as loan fees on the replacement financing, property tax prorations, or rent prorations, can be treated as boot. Review both closing statements line by line before signing.

Character of recognized gain

Recognized gain from boot is not automatically capital gain. Depreciation recapture rules apply first. On real property, recognized gain may include unrecaptured section 1250 gain taxed at up to 25 percent. Any section 1245 property, such as appliances in the duplex, can generate ordinary income. See the recapture guide.

Basis of the replacement property

IRC 1031(d) sets the basis of property received: the basis of the property exchanged, decreased by money received, and increased by gain recognized. Liability relief counts as money received. Liabilities you assume and cash you add increase basis. Form 8824 Part III walks through the computation.

In scenario B: start with $300,000 of carryover basis, subtract the $250,000 liability relief, add the $150,000 liability assumed, and add the $100,000 gain recognized. The replacement basis is $300,000. The deferred gain is preserved in the difference between that basis and the $500,000 value.

Other property as boot

Boot is not only cash and debt. Any non-like-kind property you receive is boot at its fair market value. In a real estate exchange, that can include furniture and appliances conveyed with a furnished rental, a promissory note from the buyer, or personal property thrown into the deal. Since 2017, section 1031 covers only real property, so personal property received alongside the replacement real estate is other property under IRC 1031(b). Allocate value in the contract and expect the furnishings in a furnished Gulf-front condo to be treated as boot.

Reverse the question: when boot is acceptable

Sometimes taking boot is the right answer. An investor who needs $50,000 for another purpose may be better off taking it as boot and paying tax on that slice than refinancing the replacement property later at a higher rate. Boot is taxed only up to realized gain, and the recognized gain increases the basis of the replacement property. The point is to choose it with the numbers in front of you.

Planning to avoid boot

1. Buy equal or up. Replacement value at least equal to relinquished value avoids most debt boot.
2. Reinvest all net equity. Do not take cash at either closing.
3. Replace debt or add cash. If the new loan is smaller than the old one, add cash to cover the difference.
4. Watch prorations and deposits. Pay non-transaction items with outside funds.
5. If you need cash, plan for it. Taking a known amount of boot is a choice. Discovering it on Form 8824 is a mistake.

If the exchange misses its deadlines entirely, all of the gain is taxable, not just the boot. See the deadline guide. If your intermediary is holding funds and goes under, see the intermediary failure guide.

A 1031 exchange defers what you leave invested. Everything you take out is taxed.