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What Year is “Boot” Taxable in a 1031 Exchange?
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by
Author Gary Gorman
Founding Partner,
The 1031 Exchange Experts |
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Boot is the term that the IRS uses for the part of an
exchange that is taxable. Boot generally arises for
one of two reasons: the Seller bought down, or the seller
did not reinvest all of the cash from the sale of Old
Property. Most of the year, it doesn't matter what caused
the boot: it's simply taxable. But when a transaction
overlaps the end of the year, the year of taxability
becomes important.
Suppose Fred and Sue sold their purple duplex on December
20, 2005, for $100,000 and bought their New Property
on March 1, 2006. At the time of the sale, they paid
off the mortgage of $40,000 from their lender, leaving
a balance of $60,000 that went to their intermediary.
Let's say they bought their New Property for $90,000
(they bought down), property they paid for with a new
mortgage of $40,000 and $50,000 in cash from the intermediary.
This leaves $10,000 in unspent proceeds that are returned
to them by their intermediary shortly after the purchase.
Is the $10,000 taxable in 2005 when they sold the purple
duplex or in 2006 when they bought the New Property?
With the exception of the impact that depreciation recapture
might have on their exchange, the answer is 2006 when
they actually received the cash. In a 1031 exchange,
this “cash boot” (boot caused by receipt
of cash) is subject to the installment sale rules which
mean that the proceeds are taxed when they are received.
And yes, the entire $10,000 is taxable.
In
their 2005 tax return (the year of the sale) Fred and
Sue would report the exchange on Form 8824 (Like-Kind
Exchanges form), and they would report the
cash that got deferred until 2006 on Form 6252 (Installment
Income Sale form). In their 2006 return, they
would file another Form 6252 showing the receipt and
taxability of the $10,000 from the prior year's sale.
Now let’s change our facts slightly and see what
happens. As in the example above, they sold their purple
duplex on December 20, 2005, for $100,000; and on March
1, 2006, they bought the New Property for $90,000, using
the $60,000 held by the intermediary and getting a $30,000
loan for the balance. And, as in the previous example,
they bought down by $10,000, but in this example they
used all the cash. In this case is the $10,000 buy down
taxable in 2005 when they sold the purple duplex or
in 2006 when they bought the New Property? The answer
is 2005 (when they sold the duplex) because the $10,000
buy down is “debt boot” (boot caused by
debt reduction) instead of “cash boot.”
Here’s the reason: when they sold the purple duplex
for $100,000 they used $40,000 to pay off the mortgage
on the duplex, and when they bought their New Property
they had $60,000 in cash and only needed a new mortgage
of $30,000 for the purchase. In effect they received
the excess cash at the time of the sale, which is why
it is taxable in 2005.
Be careful when you have “cash boot” that
would be taxable in the subsequent year that you consider
depreciation recapture. Working through
the items on Form 6252, you’ll discover that depreciation
recapture is taxable in the year of the sale up to the
amount of the taxable gain. In our example in which
Fred and Sue received the excess cash of $10,000 in
the subsequent year (2006), they would report depreciation
recapture, up to that amount, in 2005 (the year of the
sale). If they had taken $2,500 in depreciation prior
to the sale, then $2,500 would be taxable in 2005, and
the balance ($7,500) would be taxable in 2006.
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