The Nuances of Section 1031 Exchanges (Part Two in a Series)

• August 2, 2021
• Carey M. Heyman, CPA

Last week, in part one of a series of blog posts covering the nuances of Section 1031 exchanges, we discussed the identification period and the three-property rule. This week, we will distinguish between a realized gain and a recognized gain and discuss the concept of “boot.”

The realized gain is the potential gain, calculated as the excess of the fair market value of the property received over the tax basis of the property given up. The realized gain is “recognized,” or taxed, only to the extent of the net boot received by the taxpayer. The recognized gain is the lesser of the net boot received or the realized gain. Only the net boot received is taxable.

The term “boot,” which fun fact, does not even show up in the Internal Revenue Code, can best be explained through the following examples:

• If cash or cash equivalents are received by the taxpayer.
• If liabilities are assumed by the other party.
• If non-exchange transactional costs are paid with exchange proceeds or for the financing of the replacement property.
• When it comes to non-like kind property, such as personal property (i.e. office equipment and furniture, appliances) or property that is used for personal purposes. As a call-back to a blog post from last year, only real property is eligible for gain deferral treatment under a Section 1031 exchange.

Certain offsets are permitted in calculating boot, while others are prohibited:

• All liabilities assumed by the taxpayer as part of the exchange can be offset against all liabilities relieved of the taxpayer in the exchange.
• Cash paid by the taxpayer in the exchange can be offset against liabilities relieved of the taxpayer in the exchange.
• Cash paid by the taxpayer, can in some cases, be offset with cash received by the taxpayer.
• Cash received by the taxpayer cannot be offset with debt incurred by the taxpayer.
• The excess of liabilities assumed over liabilities relieved cannot be netted against cash boot received.
• New financing that is obtained by the taxpayer for a replacement property is either cash boot or mortgage boot, and will offset liability relief from the relinquished property.

While the Section 1031 exchange is an incredibly useful tool for real estate owners to defer gains on the sale of appreciated property, there are plenty of pitfalls with respect to boot. Don’t shake in your boot, plan ahead and call us for help!

Sources: IRS.gov, RIA Checkpoint, Bloomberg Tax

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