What Is Boot in a 1031 Exchange

Cash boot happens whenever the investor ends up holding sale proceeds that were not reinvested into the replacement property. This can happen a few different ways in a typical Washington transaction:

• The relinquished property sells for more than the replacement property costs, leaving excess proceeds with the qualified intermediary at the end of the exchange
• The investor takes any portion of the net proceeds out during the transaction, even temporarily, rather than routing all of it through the intermediary
• Closing costs paid out of exchange funds that are not considered qualifying expenses under the exchange rules can also create a small amount of boot

Any leftover cash the intermediary returns to the investor at the close of the exchange is taxable in the year received, up to the amount of the investor's realized gain, even though the rest of the transaction qualifies for deferral.

Mortgage boot, sometimes called debt-relief boot, is less intuitive than cash boot but just as common. It arises when the debt paid off on the relinquished property is greater than the debt taken on for the replacement property. An investor who pays off a $400,000 loan on a Tacoma property being sold, then buys a replacement property with only $250,000 in new financing, has $150,000 of debt relief that counts as boot, even if every dollar of cash proceeds was reinvested. The IRS treats reduced debt as an economic benefit similar to receiving cash, since the investor's liabilities went down without a matching increase in liabilities on the replacement side.

Avoiding boot generally requires two things at once: the replacement property has to be equal to or greater in value than the relinquished property, and the replacement debt has to be equal to or greater than the relinquished debt, unless the investor offsets a debt reduction with additional cash from outside the exchange. An investor moving equity out of a fully paid-off Everett rental into a leveraged Kent industrial building, for example, needs to make sure the new financing at least matches whatever debt existed on the old property, or bring in outside cash to cover the difference, or accept boot on the gap.

A common misunderstanding is that any boot voids the exchange entirely. It does not. The exchange remains valid, and the non-boot portion of the gain still defers. Boot only triggers tax on the smaller of the boot received or the total realized gain, meaning an investor with a modest amount of cash boot on a large exchange is taxed on that smaller amount, not on the full transaction. This is why some Washington investors deliberately accept a small amount of boot when a perfectly matched replacement property is not available, treating it as a partial cash-out rather than restructuring the whole exchange to avoid it.

Boot often surfaces in places investors do not anticipate rather than in an obvious cash payout. Prorated rent credited to the seller at closing, a portion of earnest money applied outside the exchange structure, or non-qualifying closing costs paid from exchange funds can each generate a small amount of boot on a transaction that otherwise looks fully deferred. Reviewing the closing statement on both the relinquished and replacement properties line by line, ideally before the closings rather than after, is the most reliable way to catch these smaller sources before they become a surprise on the following year's tax return. An investor working through a Bellevue or Spokane closing with several prorations and credits on the settlement statement benefits from having someone compare that statement against the exchange requirements before funds actually move.