By Kylie Bergmann, associate at Dawda Mann.
Section 1031 tax-deferred exchanges have become common with taxpayers who intend to reinvest the proceeds from the sale of an investment property into another investment property to defer capital gains tax. When purchasing a replacement real property as part of a 1031 exchange, the purchaser must be wary of receiving cash credits at closing for property that is not like-kind to the relinquished property. These cash credits will result in what is referred to as “boot” and are taxable to the extent of gain realized on the 1031 exchange. Since the point of a 1031 exchange is to defer capital gains tax, any 1031 exchange “boot” serves to defeat the purpose of the exchange.
To avoid cash boot, a real estate purchaser should request the seller to pay the following closing costs to the purchaser outside of closing rather than on the settlement statement:
- Rent credit
- Security deposit credit
- Utility expenses
- Repair costs
- Property liability insurance costs
- Lender’s title policy insurance premium
- Earnest money deposit credit (if buyer placed deposit in escrow out-of-pocket)
- Property tax prorations
The following customary closing costs are considered by the IRS to be incident to the transaction and will not contribute to cash boot. They can therefore appear on the settlement statement:
- Survey costs
- Environmental costs
- Escrow fees
- Owner’s title insurance policy premium
- Broker fees
- 1031 intermediary fees
- Transfer taxes
- Recording fees
- Legal fees
A taxpayer should also keep in mind it is possible to receive “mortgage boot” if the amount of mortgage debt is reduced by exchanging properties, which will cause the taxpayer to pay tax on the difference between the two mortgage balances, and “personal property boot” if the taxpayer receives anything of value that is not considered like-kind property, including vehicles, art, furniture and other personal property.
Carefully reviewing the settlement statement prior to closing to identify items that may lead to “boot” will ensure a taxpayer is able to defer all capital gains tax in a 1031 exchange transaction.