One of the many benefits of a tax-deferred exchange is the ability to defer capital gains taxes when selling and acquiring like-kind real property. This Friday Free for All discusses ways to maximize your tax deferral by minimizing taxable “boot.”
The term boot is not specifically mentioned in IRC Section 1031 or the regulations but it is used frequently when talking about 1031 exchanges. It refers to any value or equity that is not reinvested during the exchange and is subject to tax. To maximize your tax-deferral, you must reinvest for equal or greater value and equity.
To meet the value requirement, the contract sales price of the replacement property, including any purchase costs, should be equal or greater than the net selling price of your relinquished property. The net selling price is the contract sales price less any routine closing expenses and any credits paid to the buyer.
The equity is the amount of cash you have in the property. It is typically the net selling price less the balance on your mortgage. In a 1031 exchange, the net equity of your relinquished property is what is left after all routine closing costs, credits to the buyer and your mortgage payoff. This is often the amount of proceeds deposited into your exchange account with your Qualified Intermediary (QI).
When completing a 1031 exchange, anything other than routine closing costs could trigger a taxable event. Closing costs that may be paid using exchange funds, include the following:
- Real Estate Commissions
- Qualified Intermediary Fees
- Recording Fees
- Legal Fees associated with sale and/or acquisitions
- Deed Preparation
- Termite Certifications
- Title Company Fees
- Transfer Fees
- Escrow Fees
- Survey Fees
Some of the closing costs many advisors caution should not be paid using exchange funds include the following:
- Loan Costs (mortgage related fees such as points, application fee, PMI, MIP, commitment fee)
- Operating Expenses (condo association fees and fire and casualty liability insurance premiums)
- Prorata Adjustment for Property Taxes
- Insurance and other Prorata Adjustments, such as repairs, utilities, association fees
- Security Deposits and Rent Prorations: These are not closing costs but a transfer of funds related to your rental business. These should be paid with additional funds brought to the closing table.