How to Maximize Your 1031 Exchange - Simple rules help prevent taxpayers from getting the “boot”

Section 1031 “like-kind” exchanges are a valuable method of deferring the payment of capital gains taxes on the sale of qualified property. However, the rules are somewhat complicated. If the taxpayer receives cash or cash equivalents from the sale or if the taxpayer uses exchange proceeds for non-qualified expenses, it may be considered “boot” and result in reportable capital gains.

For example, when 1031 exchange proceeds are used to buy a hotel property, only the hotel building and the land will be considered “like-kind” for the purpose of the exchange. If personal property, such as the beds, desks, chairs, dining room tables and other hotel business property are included in the sale, then the taxpayer cannot pay for those items with exchange funds or it will be taxed as boot.

To avoid possible boot, a taxpayer intending to purchase personal property together with real property should purchase those items in a separate transaction. The taxpayer can also allocate the purchase price between the personal property and the real property and pay for the personal property with other funds and not exchange proceeds.

Any cash or cash equivalents, such as promissory notes received in the like-kind exchange, will be considered “boot” and taxable. In a like-kind exchange, the property sold by the taxpayer is called the “relinquished property” and the property being purchased is called the “replacement property.”

The net cash received by the taxpayer after the completion of the exchange is boot. This happens when the taxpayer did not spend all of the cash received from the sale of the relinquished property to purchase the replacement property. In addition to the receipt of cash, any property received by the taxpayer in a tax-deferred exchange which is not like-kind to the property that was sold is also considered boot.

For example, all real property is considered like-kind. A taxpayer can sell an office building and use the proceeds to buy an apartment building. However, personal property is not like-kind to real property. If a taxpayer sells real property and uses the proceeds to purchase other real property and included personal property, the fair market value of the personal property received is considered boot.

Safe exchange expenses

Exchange proceeds can be used to pay certain expenses without resulting in any tax liability for the taxpayer. The allowable costs must be directly related to the purchase or sale of the property in order to be paid for with exchange proceeds.

Let’s consider the types of expenses that would qualify as exchange expenses. They include any due-diligence inspection fees that the buyer undertakes by hiring structural engineers, environmental engineers, surveyors, and attorneys.

Realtor’s commissions, qualified intermediary’s fees, transfer taxes, deed recording fees, title insurance search costs, and the portion of the title insurance premium that is allocated to the owner’s title policy are also acceptable non-taxable uses of exchange proceeds.

Costs to avoid

Avoid paying any costs not directly related to the purchase or sale of the property. For instance, loan fees such as prepaid interest, points, commitment fees, mortgage broker commissions, and third-party costs of the bank’s inspectors such as engineers and appraisers may not be paid with exchange funds.

Even the mortgage recording fees, mortgage recording tax, and the portion of the title insurance premium that is allocated to the loan title insurance policy should be paid with other funds to avoid boot.

Closing adjustments and other closing costs are a little trickier and the taxpayer needs to be cognizant of the types of closing costs that can be paid for with exchange funds.

Generally, exchange proceeds can only be used for acquisition costs and not for typical ownership expenses. That means that closing adjustments such as rent prorations, tax prorations, security deposit adjustments, and utility adjustments should be paid with other funds and not exchange proceeds.

Any expenses that a lender or title company requires to be paid in advance as a condition of closing should also be paid with other funds and not exchange proceeds. Such costs include real estate taxes, sewer taxes, water charges, and items of similar character.

If you use exchange proceeds to purchase non-like kind property or if you use it to pay non-qualified expenses, you run the risk of having the proceeds treated as taxable boot. However, if you are careful, you will be able to maximize your 1031 exchange and not get booted by mistake.