1031 exchange boot: what it is and how to avoid a surprise tax bill

Boot is the part of a 1031 exchange that doesn't qualify for deferral. Under Section 1031(b), if you receive money or other property along with your replacement real estate, you recognize gain up to the value of that money or property.

The surprise usually comes from the debt side. Section 1031(d) treats a liability you're relieved of as if you'd received cash. So you can leave every dollar with the qualified intermediary (QI), buy a replacement property, and still owe tax because the new loan is smaller than the old one.

Cash boot and mortgage boot

Cash boot is money you receive. The usual source is exchange funds the QI releases to you because they weren't spent on replacement property.

Mortgage boot is net debt relief. The mortgage paid off when you sold counts as money received. Debt you take on with the replacement property offsets it, and so does cash you add from outside the exchange. Whatever relief is left after those offsets is boot.

One rule catches people. Extra debt doesn't cancel cash boot. Treasury Regulation 1.1031(d)-2 shows that new debt offsets debt relief, but it doesn't offset cash you take out. If you walk away with $20,000 and borrow an extra $20,000, the $20,000 is still taxable.

The two tests, in plain words

Practitioners usually boil the rules down to two checks. They're a rule of thumb, not the regulation's own wording.

1. Value. The replacement property, or the group of replacement properties, costs at least your net sale price (the sale price minus your exchange expenses), and all of the exchange money goes into it.
2. Debt. The debt on the replacement is at least as much as the debt paid off on the sale. If it's less, you cover the gap with your own cash.

Pass both and there's generally no boot. That still doesn't always mean a zero tax bill. If you used cost segregation or bonus depreciation on the property you sold, part of that depreciation can be recaptured as ordinary income even with no boot, so have your CPA check this before you sell. Fail either test and the shortfall is generally boot.

Worked examples

These are illustrative examples. They ignore closing costs and exchange expenses so the arithmetic stays clean.

You sell a rental for $500,000. At closing, $200,000 pays off the mortgage and $300,000 goes to your QI.

Example 1: cash boot. You buy a $480,000 property with a $200,000 loan and $280,000 of exchange money. That leaves $20,000 with the QI. Your exchange agreement controls when the QI can release it, generally once you've received all the replacement property you're entitled to, or at the end of the exchange period.

• Debt paid off $200,000, new debt $200,000. No mortgage boot.
• Cash received: $20,000. That's your boot.

Example 2: mortgage boot. You buy a $450,000 property using all $300,000 of exchange money and a $150,000 loan.

• Debt paid off $200,000, new debt $150,000. Net debt relief is $50,000.
• No cash comes back to you, but the $50,000 is boot.

Example 3: the fix. You buy a $500,000 property with the $300,000 of exchange money, a $150,000 loan, and $50,000 of your own cash.

• Debt relief of $50,000, offset by $50,000 of cash you paid. Net boot is $0.
• A $200,000 loan with no added cash would get you to the same place.

The same tests apply when you buy several properties. They're measured across the whole group, which our post on 1031 exchanges into multiple properties walks through.

Common ways boot sneaks in

• Taking cash at closing. Asking for some proceeds before the money reaches the QI, or taking leftover funds afterward, is cash boot.
• Lower debt on the replacement. A bigger down payment feels conservative. But if the loan is smaller than the payoff and you don't add outside cash, the difference is mortgage boot.
• Trading down in price. Buying for less than you sold usually leaves cash or debt relief behind.
• Closing costs. The Form 8824 instructions let exchange expenses reduce the boot amount. Separately, the regulation lets the QI pay customary closing items, such as commissions, transfer taxes, and title fees, without breaking the rules that keep the money out of your hands. Other settlement items are where the treatment gets less clear, so have your CPA review the settlement statements on both sides before you close.

If you're mid-exchange and the numbers don't line up, talk to a 1031 consultant about replacement properties that fit your value and debt targets.

How boot is taxed

Boot doesn't make the whole exchange taxable. You recognize gain up to the amount of boot, and the rest stays deferred. If your gain on the sale is $150,000 and you received $20,000 of boot, you generally recognize $20,000 and defer $130,000. If boot is larger than your gain, you recognize only the gain. A loss on the property you exchange isn't recognized in a like-kind exchange.

The recognized gain is taxed like gain on a sale. For rental property, the IRS taxes the portion that reflects past depreciation, called unrecaptured section 1250 gain, at a maximum 25% rate. The rest is generally capital gain, long-term if you held the property more than one year. Depending on your income, the 3.8% net investment income tax can apply on top, plus any state tax. If you used cost segregation, some of the gain can be taxed as ordinary income. Our post on capital gains on rental property covers the rates, and your CPA works out which bucket each dollar lands in.

Sizing financing to avoid mortgage boot

The cleanest fix for mortgage boot is a replacement loan at least as large as the debt you paid off. Know your payoff figure before you shop, and treat it as the minimum total debt across your replacement properties unless you plan to add cash.

DSCR loans help here because they qualify on the property's rent, not your personal income. Financing through Lineage can be sized to meet or exceed the debt on the property you sold, within the lender's loan-to-value and DSCR limits. If the loan can't reach your payoff figure, adding cash closes the gap. Loans are originated by a lending partner, not by Lineage. Our DSCR loan guide explains how lenders size them.

Lineage does not give tax or legal advice. This article explains the federal rules in general terms. Your CPA and qualified intermediary confirm how they apply to your exchange.

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