When engaging in a 1031 exchange, the goal is to defer capital gains taxes by reinvesting the proceeds from the sale of your relinquished property into a like-kind replacement property. However, if you receive cash or other non-like-kind property during the exchange, this is known as “boot,” and it can trigger the recognition of gain, making it taxable.

Here’s how it works:

In a 1031 exchange, you must reinvest all the net proceeds from the sale of your relinquished property into the replacement property to achieve full tax deferral. If you receive any cash or non-like-kind property, the IRS considers this as boot, and you will have to recognize gain to the extent of the boot received.

Let’s illustrate this with an example using Deferred.com as your qualified intermediary:

Imagine you own a rental property that you sell for $500,000. After paying off a $100,000 mortgage and $20,000 in closing costs, you have $380,000 in net proceeds. You decide to use Deferred.com as your qualified intermediary to facilitate a 1031 exchange. You identify and purchase a replacement property for $450,000.

In this scenario, you have reinvested $380,000 of your net proceeds into the replacement property, but you have received $50,000 in cash (the difference between the $450,000 purchase price and the $500,000 sale price). This $50,000 is considered boot, and you will have to recognize gain on this amount, making it taxable.

To avoid receiving boot, you should aim to purchase a replacement property of equal or greater value than the relinquished property and reinvest all net proceeds. Additionally, you should ensure that any debt on the replacement property is equal to or greater than the debt on the relinquished property to avoid mortgage boot.

At Deferred.com, we help you navigate these complexities by acting as your qualified intermediary, ensuring that you do not have direct or constructive receipt of the exchange funds. This is crucial because if you have control over the funds, it could disqualify the exchange. We hold the proceeds from the sale of your relinquished property and use them to acquire the replacement property on your behalf, helping you achieve the desired tax deferral.

By working with us, you can focus on identifying suitable replacement properties and meeting the 45-day identification and 180-day exchange completion deadlines, while we handle the technical aspects of the exchange process. This way, you can maximize your tax deferral benefits and avoid the pitfalls of receiving boot.