Requirements for Full Tax Deferral

The Big Picture

Many taxpayers confuse what is required for full tax deferral in a 1031 exchange with calculations involved in determining the capital gain and capital gain taxes that would be owed absent a 1031 exchange. The requirements for full tax deferral are different than the capital gain tax and basis computations.

Why it Matters:

To defer all tax in a 1031 exchange:

1. Reinvest the entire net equity (net proceeds) in one or more “like-kind” replacement properties; and –
2. Replace all debt that was extinguished on the sale of the relinquished property with an equal or greater amount of debt on replacement properties or add cash to replace such loan payoff.

What is Boot?

The term “boot” refers to any property received in an exchange that is not considered like-kind real property. Cash boot refers to the receipt of cash. Mortgage boot, which can also be referred to as debt relief boot, is a term describing a taxpayer’s reduction in mortgage liabilities on the purchase of a replacement property or properties.

Boot may result in a taxable event. To determine the taxes that may be due, the taxpayer’s tax advisor must calculate the realized capital gain. Next, the amount of boot, along with any depreciation recapture, must be determined. The tax advisor will then need to determine the taxes owed for federal capital gain taxes, the depreciation recapture, state taxes (when applicable) and the Section 1411 net investment income tax (when applicable). Finally, a tax advisor should review the taxpayer’s specific situation to determine whether there are additional tax issues that may offset any current capital gain tax liabilities.

The Takeway

Some taxpayers think that all they have to do to defer all tax is to reinvest their gain in replacement property. Others believe it is only the equity that has to be reinvested. Full deferral requires reinvesting all equity and replacing all debt.