What is Boot? Why Do I Have to Pay Taxes On It?

Over the last few posts, we discussed 1031 exchanges and how, if the requirements are met, they allow for tax-deferred exchanges of one property for another. I mentioned that even though the exchange of the property itself is tax-deferred, there may be other elements to the exchange that are taxable. Taxable benefits received as part of a 1031 exchange are referred to as boot.

Image from www.atlas1031.com

There are essentially two forms of boot. The first is any property received in the exchange that is not like-kind to the property relinquished. The most common form of this type of boot is cash, but it can be any type of property that is not like-kind.

For example, you own a rental property with a fair market value of $1.2 million. You are willing to exchange it for another rental property with a fair market value of $1 million, but you probably want to be compensated for the difference in values by receiving cash for $200,000. That cash is boot.

The second form of boot is debt relief. If the relinquished property is subject to debt and as part of the exchange you are relieved of that debt, you are treated as having received cash.

Lets say you own a commercial building with a fair market value of $1.5 million, but it has a mortgage of $500,000 attached to it. You exchange it for another property with a fair market value of $1.5 million. At first glance, it may look like there is no boot because nothing except for the rental properties were exchanged. However, you were relieved of $500,000 of debt and that is treated the same as if you had received that much in cash.

Of course, there could be boot going both ways in the transaction. In that case, there are rules that allows certain types of boot to be offset by other boot, leaving you with "net boot." These offsetting rules are:

1. Cash paid to the other party offsets cash received.
2. Cash paid to the other party offsets any mortgage (debt) relief.
3. Mortgage (debt) assumption offsets mortgage (debt) relief.
4. Exchange expenses offsets cash received.
5. Mortgage (debt) assumption does not offset cash received.

Furthermore, just because you have boot does not necessarily mean that it will be subject to tax. Boot is only taxable to the extent that there is gain. For 1031 exchanges, the amount of gain recognized is equal to the lesser of: 1) the amount of gain realized in the exchange; or 2) the value of the boot received.

Lets look at another example. Several years ago you purchased a rental property in San Diego for $700,000. The property now has a fair market value of $800,000 with a mortgage of $200,000. You enter into a 1031 exchange and receive a property with a fair market value of $500,000 with no debt and cash of $100,000.

If you had sold the original property in a traditional sale, you would have had a gain of $100,000 ($800,000 value less $700,000 purchase price). Because you did a 1031 exchange instead, you received a like-kind property with a fair market value of $500,000 and boot of $300,000 ($200,000 of debt relief and $100,000 cash). In this case, you would not be required to recognize all $300,000 of boot, only the $100,000 of gain that you would have recognized in a traditional sale.

Lets look at the same scenario, except that you had purchased the property for only $200,000. In this case, if you had sold the property you would realize a gain of $600,000. However, in a 1031 exchange you only have to recognize $300,000 of gain because that is the amount of boot you received.

If you have any questions about 1031 exchanges and boot, please feel free to send me an e-mail.

Can I Take Advantage of a 1031 Exchange?

As we discussed in the last blog post, a 1031 exchange is a tax-deferred, like-kind exchange of property held for productive use or investment for another property held for productive use or investment. In English, it allows you to trade one property for another property without paying income taxes at that time.

Image from www.kolotv.com

As you can imagine, this is a major benefit to taxpayers because it means that you can defer paying thousands of dollars (or far more) in taxes for years. Obviously, such a beneficial tax code provision is going to have very strict requirements that must be met in order to utilize it.

The first requirement is that the property that you are disposing of must have been held for productive use in a trade or business or for investment.  This means that it cannot be personal use property, such as your principal residence or a vacation home.

The second requirement is that the property that you are acquiring must be used either in a trade or business or for investment. How the other party used the property is irrelevant, the test is how you will use the property. The basic idea is that if you are going to be allowed to defer taxes from the "sale" of the relinquished property, you have to use the replacement property in a similar manner.

The next requirement is that the property cannot be: inventory, stock, bonds, notes or other evidence of indebtedness, interests in a partnership, certificates of trusts or beneficial interests, or choses in action.

Finally, the replacement property must be of a "like kind" to the property relinquished. All real estate located in the United States, whether it is improved or unimproved, is considered to be like-kind to other real estate located in the United States. However, real estate located in the United States is not like-kind to real estate outside of the United States.

Unlike with real estate, not all personal property (e.g., equipment, furniture, etc.) is considered to be like-kind to other personal property.  In order to be like-kind, the personal property must be in the same asset class (and if livestock, must be the same gender).  In addition, as with real estate, personal property located in the United States is not like-kind to personal property outside of the United States.

There are additional timing requirements that must be met if the property exchange does not occur simultaneously, but we will discuss that further in a future blog post.

If you would like to know if your transaction would qualify under Section 1031, please send me an e-mail.

What is a 1031 Exchange?

If you own rental real estate, you are probably concerned about the tax hit you will take when you sell one property to invest in another property. If you talk to realtors or tax professionals about it, they would probably suggest that you consider a Section 1031 exchange.

So, what then is a 1031 exchange? It is a tax-deferred, like-kind exchange of one investment for another investment.

The Hasbro game Monopoly actually provides a great conceptual basis for how a 1031 exchange is intended to work.

Early in the game, you will use your cash to buy various properties. Eventually, one of the other players will acquire a property that you need and is not willing to sell it to you for cash (or you may not have enough cash on hand to buy it). Instead, the other player suggests trading his property for one of yours.

When this trade happens, you do not have to pay the bank for the difference in value between your property and the other player's property. It is simply a trade between the two players.

In the real world, you may acquire various investment properties throughout your life. At some point in your life, you may reach a point where you want to sell one of your investment properties and purchase another investment property. Without Section 1031, the owner of each property would have to pay income taxes on their individual gains from the sale of the properties. However, Section 1031 allows each landowner to simply trade their properties like they would in a game of Monopoly while deferring paying any taxes until the eventual sale (not 1031 exchange) of a property occurs.

Of course, few trades are this easy either in Monopoly or real life. In Monopoly, if the two properties do not have exactly the same value to both players, then the player with the more valuable property may demand money in addition to the property. While there are no consequences to that in the game, in real life the receipt of cash in a 1031 exchange is referred to as "boot" and is taxable. Even beyond the difference in values between the properties, few trades in the real world are as simple as they are in a game of Monopoly because many properties are burdened with mortgages which can have tax consequences. Furthermore, in the real world it can be difficult to find two landowners who are willing to trade properties, so to make a 1031 exchange work a qualified intermediary may have to be used to work around this problem.

Over the next few posts, we will discuss the formal requirements of a Section 1031 exchange, taxable transactions connected to a 1031 exchange, your basis in the new property, and transactions involving qualified intermediaries. In the meantime, if you would like to discuss 1031 exchanges or any other tax issue please send me an e-mail.

What Happens When You Sell a Passive Activity Business or Real Estate?

As you now know, if the passive activity rules apply to your business or real estate then you may not be able to deduct all your losses.  Passive activity losses can only be used to offset passive activity income (they cannot be used as a deduction against your ordinary income).  If you do not have any passive activity income, the loss is suspended and carries forward to the next year until you eventually have passive activity income.  But what happens if you dispose of the passive activity business or real estate before you are entitled to use all of the passive activity losses?

If that is the case, and it is the entire activity that is being disposed of, then special rules apply.  If the disposition is part of a fully taxable transaction (such as a sale), then the losses are recognized in the following order:

1) The current year passive activity losses are first used to offset all passive activity income from other activities for the year;

2) Then, the passive activity losses are deducted against ordinary income.

Lets look at an example to get a better understanding of what this means.

Joe is a limited partner in a small business, and owns one rental property.  Joe is not a real estate professional and does not actively participate in the management of his rental properties. In 2015, the small business will have income of $5,000.  The rental property has a loss of $3,000 prior to its sale during the year.  The property had a tax loss for a number of years prior, and had unused passive activities losses of $30,000.

Because the sale of the property is a taxable event and represents the complete disposition of his ownership interest in that property, Joe is allowed to recognize his prior unused passive activity losses.  First, though, he must offset the current year passive losses of $3,000 against the $5,000 of passive activity income from the small business.  After that, he is entitled to deduct the previously unused passive activity losses of $30,000.

However, the rules are different if the disposition of the business or real estate is instead the result of the owner's death.  In that case, the current year passive losses are still used to offset the current year passive activity income, but only to a certain extent.  They will only be allowed to be used to the extent that the losses exceed the "step-up" in basis that occurs when property is transferred through inheritance.  In other words, the losses are reduced by the amount of basis step-up.  Any unused passive activity losses then disappear- they cannot be used as a deduction against ordinary income.

If you have any questions, please send me an e-mail.