Not every 1031 exchange fully defers the tax. An exchange can clear the like-kind, deadline, and taxpayer requirements and still produce a taxable component if the reinvestment is not complete in the technical sense. That taxable component is called boot. Understanding how boot arises, how it is measured, and when it is tolerable by design is a useful part of preparing for any exchange.

This article covers the two common forms of boot, how the IRS measures the fully-deferred threshold, and the logic behind a partial exchange that accepts some boot intentionally.

The full-deferral threshold

Section 1031 defers the full gain when two conditions are met. The aggregate value of the replacement property equals or exceeds the value of the relinquished property, and all net proceeds from the relinquished sale are reinvested. Debt relieved on the relinquished side must be replaced by equal or greater debt on the replacement side, or the difference must be made up in cash.

Any shortfall produces taxable recognition in the year of the exchange. The shortfall is the boot. Boot is limited to the amount of realized gain on the exchange, which means an exchanger cannot be taxed on more than the gain the exchange would have produced in a fully taxable sale. The boot recognized is taxed as capital gain (and, if applicable, as depreciation recapture up to the recapture amount).

Cash boot

Cash boot is any net proceeds from the relinquished sale that are not reinvested into replacement property. It shows up in three common ways.

  • Unused proceeds at the end of the exchange. The exchanger acquires replacement property for less than the full net sale price and takes receipt of the remainder. The difference is cash boot.
  • Proceeds held back from the QI.An exchanger who retains some proceeds outside the qualified intermediary's account for non-exchange purposes has taken constructive receipt. Those funds are cash boot.
  • Personal expenses paid from exchange funds. Exchange funds used for anything other than qualified acquisition costs can become cash boot. Acceptable uses generally include the purchase price, title fees, transfer taxes, QI fees, and customary closing costs. Repairs, financing fees tied to the exchanger's broader finances, or debt service on the replacement property do not qualify.

Mortgage boot

Mortgage boot arises when debt carried forward on the replacement side is less than debt relieved on the relinquished side. If the relinquished property carried a $400,000 mortgage and the replacement property has only $300,000 of debt, the $100,000 difference is mortgage boot, unless the exchanger adds $100,000 of outside cash to the replacement purchase to offset it.

The same logic runs in the other direction. An exchanger can offset cash boot by increasing debt on the replacement side. Treasury regulations permit the two forms of boot to be netted against each other under Section 1.1031(d)-2, with the result that only the net shortfall is taxed.

Mortgage boot is often the less obvious of the two. An exchanger focused on reinvesting the full cash proceeds can still produce a taxable event by accepting a smaller mortgage on the replacement property. DST structures sometimes include leveraged offerings designed specifically to help exchangers match their relinquished debt. Non-leveraged DSTs may require an exchanger to add outside cash to the purchase to avoid mortgage boot.

When boot is tolerated on purpose

Some exchanges accept boot intentionally. A partial exchange produces a taxable component by design because the investor wants to take some cash out at closing. The reasons vary.

  • An investor selling a highly appreciated property may want partial liquidity for a specific purpose (education, healthcare, estate distribution) while continuing to defer the majority of the gain.
  • An investor with losses elsewhere in the tax year may be able to absorb a controlled amount of recognized gain without paying additional tax.
  • An investor reducing the size of the real-estate position may prefer recognizing a modest portion of the gain at a known rate rather than structuring around it.

A partial exchange is not a failed exchange. It is a planned one. The key difference is intent. An exchange that accidentally produces boot at closing is a mistake. An exchange that produces the same boot as part of a plan reviewed with the tax advisor in advance is a tool.

How boot gets reported

Form 8824 captures boot in the year of the exchange. Line 15 reports total boot received (cash and mortgage). The recognized gain is the lesser of realized gain or total boot received. The replacement property's basis is then adjusted to reflect the recognized gain.

The accounting matters beyond the immediate tax year. Depreciation recapture on the recognized portion follows the same rules as any other real-estate sale, with a federal rate up to 25 percent under Section 1250 for depreciation previously claimed. State tax treatment varies. An exchanger with significant depreciation history should work through the expected recapture with their CPA before committing to a partial exchange strategy.

Avoiding unplanned boot

Three practices avoid most accidental boot situations.

  1. Size the replacement property to the full sale price, including debt. Aggregate replacement value should equal or exceed the relinquished sale price. Aggregate replacement debt should equal or exceed relinquished debt relieved, or the difference should be made up in cash.
  2. Include all qualified costs in the planned acquisition. Work with the QI to confirm that customary closing costs (title, transfer taxes, QI fees, standard attorney fees) will be covered from exchange funds. Non-qualified expenses should be budgeted from outside the exchange account.
  3. Check debt placement early.When a replacement property is a DST, confirm the offering's leverage ratio against the relinquished debt before committing funds. Non-leveraged DSTs are not wrong, but they require the exchanger to bring additional cash to avoid mortgage boot.

The place of boot in a clean exchange

A well-run exchange either has no boot or has planned boot the exchanger and their advisors agreed to in advance. Surprise boot at closing is rarely irreversible, but correcting it mid-transaction is harder than preventing it. An hour of planning with the QI and tax advisor in the weeks before the relinquished closing is the most reliable way to avoid the problem.