1031 exchange rules apply to Internal Revenue Code Section 1031 tax deferred exchanges. A 1031 exchange allows resident or non-resident United States federal taxpayers to defer capital gains and recaptured deprecation taxes when exchanging real or personal property held for productive use in a trade, business or for investment for like-kind real or personal property held for productive use in a trade, business or for investment. The tax otherwise paid in a traditional sale is deferred indefinitely until the replacement property is sold or another 1031 exchange is initiated.
One of the 1031 exchange rules is that the equity and debt in the replacement property must be equal to or greater than the equity and debt in the relinquished or old property. On the settlement statement the net equity or Cash Due Seller is the result of the gross selling price less debt retired or paid off less selling expenses such as sales commissions and closing costs. The net equity plus the debt retired must be less than or equal to the equity or cash and new debt on the replacement property.
In the example below, the net equity of $135,000 and the $50,000 of retired debt should be equal to or greater in the replacement property for a target purchase price of at least $185,000. In a 1031 exchange, the goal to defer the taxes is to buy a property of greater value than what was sold.
Equity and Mortgage Boot
To defer 100 percent of the capital gain and recaptured depreciation taxes, a replacement property of $185,000 must be acquired; otherwise a tax on the difference is triggered. The difference is known as boot, or a benefit that is received either in cash or equity boot or reduction in debt or mortgage boot. Additional cash offsets debt, but additional debt does not offset cash. The term boot is thought to have originated during the days of horse trading when the seller may have received an additional benefit beyond the horse swap that was placed in a boot for safe keeping while traveling.
1031 Exchange Napkin Test
The 1031 napkin test is a familiar test to determine the debt and equity outcome for both the sale of the old property and replacement property purchase. The goal is to quickly see whether the debt and equity are equal to or greater in the replacement property.
The sale of property for $200,000 and the purchase of property for $230,000 results in higher debt and greater equity in the new property and a qualifying 1031 exchange. Another option for the taxpayer if cash is available is to have less debt in the replacement property and more equity. In fact, debt in the replacement property is not required and can be offset with all cash.
Partial 1031 Exchange
If the net equity or debt is not replaced in the new property, a partial 1031 exchange is fine, though once the replacement reaches 50 percent of the old property net selling price, the tax that is paid on the boot may equal the taxes triggered without an exchange. For a brief article on Partial Exchanges go to:
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Contact Us
Atlas 1031 has been accommodating all types of exchanges for over 16 years. Should you have any questions regarding exchange rules or specifically “boot”, please contact us through the consultation on this page or call our office at 800-227-1031. We look forward to hearing from you.
