At 1031 Exchange Place, our exchange experts are up to speed on all the important rules and regulations that go into a 1031 tax deferred exchange. Navigating this process can be complex, and even a single mistake can torpedo the entire exchange in the eyes of the IRS, so working with pros like ours is a must.
One area we’re very experienced with? The presence of “boot” during an exchange, and helping clients receive this benefit through the use of a mortgage boot. Let’s go over the basics of what this means, which 1031 exchange rules it helps you comply with, and how you can ensure you’re always in compliance in this area.
Equity and Mortgage Boot Basics
One important 1031 exchange rule states that equity and debt for the replacement property being used must be equal to or greater than said equity and debt in the relinquished property. Net equity on a settlement statement (or cash due seller) results from the gross selling price minus retired or paid off debt, selling expenses, sales commissions and closing costs.
If a replacement property of at least the same net equity value is not purchased, a tax difference will be triggered. This tax difference is called “boot,” a benefit that sellers receive either in cash or equity, or as a reduction in debt or a mortgage boot. Additional cash is allowed to offset debt here, but additional debt does not offset cash.
Using a basic example, let’s say you are selling a property for $200,000, less debt of $50,000 and selling expenses of $15,000. This leaves you with net equity of $135,000 – this plus your retired debt number ($50,000) combine to dictate that a replacement property worth at least $185,000 must be acquired to avoid a boot being triggered.
This is a simple test – one that can be done on the back of a napkin, hence the name – that will help you determine the debt and equity areas for both sides of the sale and replacement purchase. Simply line up the sales price, debt, selling expenses and resulting final equity for the relinquished property on one side, then the purchase price, debt, purchase expenses and resulting net equity on the other.
If net equity or debt is not replaced with the new property, it’s possible to use a partial 1031 exchange. However, once the replacement reaches a point where it’s at 50 percent of the net selling price of the relinquished property, tax paid on the boot might actually equal taxes triggered without an exchange. Speak to our pros about whether a partial exchange here makes sense given your situation.
For more on how a boot might be used in a 1031 exchange, either via cash proceeds or a reduction in debt or a mortgage, speak to the pros at 1031 Exchange Place today.