1031 Exchange Example With Boot

Boot is defined as anything in the 1031 exchange that is not like-kind property. We’ll take a look at some examples of cash boot and mortgage boot.

I’d like to thank 1031x.com for providing a great resource on this topic. This article is by far the best I’ve found online for explaining many of the finer points of calculating boot in a 1031 exchange.

If you want to avoid boot altogether, simply follow these two rules:

Rule #1: Buy a property worth more than the one you’re selling

Rule #2: Allocate all cash received in the sale of the old property to the purchase of the new one

We’ll see how these two rules can save you from being taxed during a 1031 exchange. Now let’s get to it.

Calculating Tax Basis

First, let’s briefly talk about calculating your tax basis on the sale of a property you own. We’ll need this number later for our examples.

You’ll need the total cost of purchasing the property in the first place and the net sales price of the property (sales price minus expenses like closing costs).

Tax Basis = Net Sales Price of Old Property – Total Cost of New Property

Like all things tax related, calculating tax basis is more complicated than it seems. Check out this more in depth (and accurate) explanation for calculating tax basis on a property being sold in a 1031 exchange.

Example With Cash Boot

Now that we’ve gotten that out of the way let’s get to the examples.

Let’s say we’ve decided to sell a property and use the 1031 like-kind exchange to defer taxes.

Cash Boot Example

First let’s calculate our tax basis:

Cost to Purchase in 2001 = $135,000
Net Sales Price in 2018 = $225,000
Tax Basis = $90,000

This $90,000 is the amount of capital gains we’ve realized. Now let’s look at the amount of cash we are taking out of the property.

Net Sales Price in 2018 = $225,000
Principal Left on Mortgage = $0
Cash Taken Out = $225,000

Since we own the property outright, we’ll take out the full $225,000 sales price to put towards another property. Remember, we’re taking out $225,000 cash, but we’re only at risk for being taxed on the $90,000 capital gain.

We’ve found a property to purchase as well, and it is being sold for $205,000.

Cash from Sale = $225,000
Purchase Price = $205,000
Cash Boot = $20,000

Since we’ve bought a property worth less than the one we sold, we ended up taking out $20,000 in cash. This $20,000 is not of like-kind with the property sold, so it is now subject to taxation at capital gains rates.

Example With Mortgage Boot

Taking cash out of the sale is the simplest example of boot in a 1031 exchange. Mortgage boot is a different breed.

If you carry a debt (mortgage) on the property you’re selling in the exchange, and by purchasing another property you lower your debt burden, you will realize a mortgage boot.

Let’s look at an example:

Mortgage boot example

First, calculate your tax basis for the property you’re selling:

Cost to Purchase in 2011 – $275,000
Net Sales Price in 2019 – $350,000
Tax Basis = $75,000

So you’re potentially on the hook for taxation on $75,000 of gains. And now let’s look at the cash taken out:

Net Sales Price in 2019 = $350,000
Principle Left on Mortgage = $200,000
Cash Taken Out = $150,000

Let’s say we decide to purchase a house at $250,000 and the entire $150,000 you took out of the sale goes straight into the new house:

You won’t have any cash boot, but the IRS sees a different problem. You’ve lowered your debt responsibility.

Debt on Property Sold = $200,000
Debt on Property Purchased = $100,000
Total Mortgage Boot = $100,000

In this case you now have $100,000 less in debt carried over to the new property. You will still be liable for capital gains taxes paid on the full $75,000 tax basis for the property you sold since your mortgage boot is greater than your tax basis.

Example With Both Cash and Mortgage Boot

To see a 1031 exchange example with both cash and mortgage boot, we’ll go back to our first example with a slight change.

Here are the important numbers for the property being sold.

Cost to purchase in 2001 = $135,000
Net Sales Price in 2018 = $225,000
Tax Basis = $90,000

Net Sales Price in 2018 = $225,000
Principal Left on Mortgage = $50,000
Cash Taken Out = $175,000

Now let’s say you purchase a house at $160,000. You can pay for the full purchase price of the property with the cash you got from selling your old property.

You end up with $15,000 in extra cash and you’ve also gotten rid of the $50,000 mortgage you had. We just total these together to get the net boot

Cash boot = $15,000 ($175,000 cash – $160,000 purchase price)
Mortgage boot = $50,000 (went from $50,000 mortgage to $0)
Net Boot = $65,000

You are taxed on “net boot”

Surprise surprise, there is more than meets the eye for the rules to calculating the boot you will be taxed on. There are ways to offset boot accrued in exchanges.

This article has additional info on net boot and the boot offset rules.

Rules To Avoid Boot

There are two rules you can follow to nearly always guarantee that you will defer your entire tax basis during a 1031 exchange.

Rule #1: Buy a property worth more than the one you’re selling

Rule #2: Allocate all cash received in the sale of the old property to the purchase of the new one

If you follow these rules, you won’t be taxed for the sale of your real estate. Using Rule 1 guarantees you’ll avoid mortgage boot and using Rule 2 guarantees you’ll avoid cash boot.

Let’s revisit our three examples and see where we went wrong.

Cash Boot Example – Revisited

Here was our situation that ended in cash boot.

Sold Property for $225,000
Bought Property for $205,000
Cash Boot $20,000

We ended up with cash boot because we broke Rule #1. We bought a property that was valued less than the property we sold.

If we had bought a property worth say $250,000, we wouldn’t have had any tax obligation, as long as we put all the cash from the sale of our property to the purchase of the new property.

Mortgage Boot Example – Revisited

And here was the situation that ended in us having mortgage boot.

Sold Property for $350,000
Bought Property for $250,000
Mortgage Boot $100,000

Again it’s Rule #1 that was broken here. We didn’t take any cash out, but we benefited from lowering our debt obligation by purchasing a cheaper property.

If we had bought a property worth more than the $350,000 sales price, we could have avoided the tax obligation.

Mortgage and Cash Boot Example – Revisited

The last example is another one where Rule #1 was broken.

Sold Property for $225,000
Bought Property for $160,000
Net Boot $65,000

In this example we walked away with $15,000 cash and lowered our debt obligation by $50,000. And again purchasing real estate worth more than the property we sold could have avoided this problem.

Example of Breaking Rule#2

Rule #2 would only ever be broken if you pulled cash out of the sale of your old property and assumed additional debt on the new one. Here’s the example.

Cost to purchase in 1996 = $75,000
Net Sales Price in 2019 = $245,000
Tax Basis = $170,000

Net Sales Price in 2018 = $245,000
Principal Left on Mortgage = $50,000
Cash Taken Out = $195,000

This set up seems familiar, but let’s do something a bit different on the purchase of the new real estate. We’re going to take cash out and add it to the mortgage of the new property.

Purchase Price of New Property = $400,000
Down Payment on New Property = $150,000
Mortgage Amount on New Property = $250,000
Cash Taken Out = $45,000
Cash Boot = $45,000

So we followed Rule #1 and purchased real estate with greater value than the property we sold. But we are taking $45,000 in cash out of that sale. Only $150,000 of the $195,000 that we received in the sale is actually going towards the purchase of the new real estate.

This results in a cash boot of $45,000 that will be taxed at the capital gains rate.

We could have avoided this by putting that $45,000 towards the down payment of the new property.

Conclusion

The 1031 exchange has a lot of rules, but you can avoid cash boot and mortgage boot on your exchange by following our two rules. Exchange for a more valuable property and put all cash from the sale of the old property into the purchase of the new property.

I hope my examples helped clear up this small part of the 1031 exchange process.

Happy investing.