One of the common concerns I hear from potential clients when we discuss 1031 exchanges is the treatment of mortgage debt. Many worry that mortgage debt on their property will complicate their future exchange. This worry isn’t without foundation: It would seem reasonable to suspect that a 1031 like-kind exchange would need to involve property free of any pre-existing liabilities.
As it turns out, mortgage debt encumbering your property is not a barrier to carrying out a 1031 exchange. In fact, it is very possible to have a smooth 1031 exchange transaction even when mortgage debt is present. However, mortgage debt can make 1031 exchanges a bit more complex, even though it won’t necessarily create tax liabilities.
The key to understanding mortgage debt—or “mortgage boot”—is to keep in mind that tax liabilities are not created as long as an exchange is properly balanced. A balanced real property 1031 exchange consists of four main components:
1. You need to buy a replacement property in which the purchase price is equal to or greater than the value of your relinquished property.
2. You are required to replace the amount of mortgage debt on the relinquished property (you can also increase leverage) if any, with new mortgage debt on the replacement property.
3. You must exchange all sale proceeds.
4. You must buy real estate (non-cash items).
The Many Varieties of Boot
There are a few common types of boot in 1031 transactions. Along with mortgage boot (discussed in more detail below), perhaps the most common type of boot traded in 1031 exchanges is cash.
Cash Boot occurs when the exchanger receives cash as part of the exchange. The exchanger doesn’t necessarily have to receive the cash proceeds in order for it to be taxable. For example, when a replacement property requires capital expenditure dollars to fund certain upgrades at the property that will be carried out in the future but the exchanger wants to reserve the money from sale proceeds, then these capital expenditure dollars do not represent like-kind property and, therefore, can be cash boot.
Aside from cash, other common types of boot include personal property and real estate that is not like-kind (for instance, a personal residence). When you negotiate your 1031 exchange, you can use whatever type of supplemental property you think will help complete your transaction. As long as the supplemental material remains secondary to the underlying exchange of like-kind property, you will still qualify for section 1031 treatment.
When Mortgage Debt Is Considered the Receipt of Cash
In a 1031 exchange, if you receive property that has less mortgage debt than the property you transferred, this imbalance in your favor will be treated the same as the receipt of cash. This is how mortgage boot is created:
Mortgage boot is triggered when you have received a property with less debt attached than your own property. The tax code treats this reduction of debt as a form of income. Unless your 1031 transaction is somehow balanced out with additional cash or personal property, your debt reduction will create a tax liability.
For example, say you intend to exchange a property with a value of $2 million and a mortgage debt of $400,000 for a property with a value of $2 million and a mortgage debt of $300,000. Absent any supplemental material exchanged in the deal, the mortgage boot created by the exchange will result in $100,000 of taxable income.
Mortgage Boot Can Be Offset to Avoid Tax Liability
As mentioned earlier, 1031 exchanges are all about creating a balanced transaction, and just because you wish to acquire a replacement property with less mortgage debt does not necessarily mean that you will incur a tax liability. In both cases of cash boot and mortgage boot, additional cash can be added to offset these effects.
Though mortgage debt can add a bit of complexity to your 1031 exchange, it should in no way act as a deterrent. The presence of such debt simply means that you will need to get a bit more creative to achieve maximum tax deferral.
While it may be possible to summon this type of creativity on your own, partnering with a capable real estate investment management firm to help deal with mortgage boot in your 1031 exchange is almost always the best option. Mortgage boot will not necessarily lead to taxable gain, but you will likely need the assistance of experts to address all of the variables. At CWS Capital Partners, we’ve helped many clients successfully complete 1031 exchanges into high-quality apartment communities.
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