How Is Boot Taxed in a 1031 Exchange?

A 1031 exchange allows real estate investors to defer capital gains taxes when swapping one investment property for another of equal or greater value. However, if non-like-kind property or cash is received, it is considered “boot” and may be taxable.

Understanding how boot is taxed is essential for investors aiming to maximize tax deferral benefits. Even a small amount can trigger unexpected tax liability, reducing the advantages of the exchange.

Types of Boot

Boot includes anything received in the transaction that is not like-kind property, potentially creating a taxable event. The most common types are cash, debt relief, and other property.

Cash

Cash boot occurs when an investor receives money from the exchange, either intentionally or unintentionally. This happens when the replacement property costs less than the relinquished property, leaving excess funds. It can also result from withdrawing any portion of the proceeds for personal use.

For example, if an investor sells a property for $500,000 and acquires a new one for $450,000, the $50,000 difference is considered cash boot. Even if these funds remain with the qualified intermediary temporarily, they are taxable if not applied toward the new property. Refunded earnest money or prorated rent collected at closing may also be classified as boot. To avoid this, investors must reinvest all proceeds into the replacement property or use them for qualified exchange expenses.

Debt Relief

Debt boot arises when the mortgage or financing on the relinquished property exceeds that on the replacement property. If the investor does not contribute additional funds to cover the difference, the shortfall is taxable.

For instance, if a property with a $300,000 mortgage is sold and the replacement property has a $250,000 mortgage, the $50,000 reduction in debt is considered boot. The IRS treats this as a financial benefit, similar to receiving cash. However, contributing $50,000 in additional equity to the replacement purchase can eliminate boot.

Debt boot is often overlooked because investors focus on purchase price rather than financing details. Ensuring the new mortgage is equal to or greater than the previous debt can help prevent taxable exposure. Consulting a tax professional before finalizing the exchange can help structure the transaction properly.

Other Property

Non-like-kind property received in an exchange is also classified as boot. This includes personal property, stocks, bonds, or any asset that does not meet the IRS definition of real property for 1031 purposes. If a transaction includes furniture, equipment, or other tangible assets, they are taxable.

For example, if an investor sells an apartment building and acquires a commercial property that includes office furniture, the value of that furniture is considered boot. Even though it is part of the deal, it does not qualify as like-kind under 1031 exchange rules. The fair market value of any such non-qualifying items must be reported as taxable income.

Seller financing can also create boot. If the seller of the replacement property provides financing instead of the buyer securing a traditional loan, the promissory note received may be taxable. Investors should review the terms of their exchange carefully to ensure compliance with IRS guidelines.

Tax Treatment of Boot

Boot received in a 1031 exchange is taxable in the year the transaction occurs. Unlike deferred gains on like-kind property, boot is subject to immediate taxation, typically as a capital gain. The tax rate depends on how long the relinquished property was held. In 2024, long-term capital gains are taxed at 0%, 15%, or 20%, depending on taxable income. If the property was held for less than a year, the gain is taxed as ordinary income, which can be significantly higher.

The taxable portion of boot is determined by calculating the total realized gain on the exchange and identifying the amount of boot received. Realized gain is the difference between the original purchase price (adjusted for depreciation and capital improvements) and the sale price of the relinquished property. If the boot received is less than the total gain, only the boot amount is taxable. If it exceeds the gain, the entire gain is taxed, but any additional boot is not subject to further taxation.

Depreciation recapture can also impact taxation. If the relinquished property was depreciated over time, the IRS requires a portion of the gain to be taxed at a higher rate under Section 1250 of the tax code. This means that part of the gain associated with prior depreciation deductions may be taxed at a maximum rate of 25% rather than the lower capital gains rate. This is particularly relevant for investors who have owned rental properties for many years and have taken significant depreciation deductions.

Boot can also result in a combination of capital gains and ordinary income taxation. If an investor receives boot in the form of forgiven debt, any portion that exceeds the adjusted basis of the relinquished property could be treated as taxable income under cancellation of debt rules. This is particularly relevant for distressed properties or transactions involving seller financing. Investors should analyze their adjusted basis and outstanding liabilities to avoid unexpected tax consequences.

Reporting Boot on Returns

Properly documenting boot on tax returns is necessary for compliance with IRS regulations. Investors must report the exchange on IRS Form 8824, which details the properties involved, the realized gain, and any boot received. This form determines the taxable portion of the transaction and must be filed in the same year the exchange occurs. Any gain from boot is then carried over to Schedule D of Form 1040, where it is classified as either short-term or long-term capital gain, depending on the holding period of the relinquished property.

Since boot can take different forms, accurately categorizing it on tax filings is important. If the boot consists of cash or other property, the fair market value must be determined at the time of the exchange. This valuation should be well-documented, as discrepancies can trigger IRS scrutiny. In cases where boot arises from debt relief, the reduction in liabilities must be reflected correctly to ensure the taxable gain is not understated. Errors in reporting can lead to audits, interest charges, and additional tax liabilities, making it essential for investors to verify all figures before filing.

Taxpayers who receive boot may also need to consider estimated tax payments. Because boot is taxable in the year of the exchange, investors anticipating a significant gain may be required to make quarterly estimated tax payments to avoid underpayment penalties. The IRS imposes penalties if at least 90% of the current year’s tax liability or 100% of the prior year’s tax is not paid throughout the year. This is particularly relevant for high-value exchanges where the taxable gain from boot could substantially increase overall tax obligations.