Understanding mortgage boot in a section 1031 exchange
Mortgage boot is one of the two most common types of boot encountered in a 1031 exchange. The other common type of boot is cash boot. It’s a rare thing to encounter another type of boot in an exchange. In technical lingo, boot is any property received as consideration in an exchange which is not of a like-kind to the relinquished property. Today, because of the change made by the TCJA, this means any personal property received will constitute boot. If a taxpayer receives $50,000 of stock on top of their sale, then he or she will have “stock boot.” Clients often have questions about mortgage boot because it’s common to see existing loans on relinquished property. Clients are often confused about mortgage boot because they tend to assume that Section 1031 is primarily about spending their cash as opposed to deferring capital gain. In this post, we will discuss in detail the phenomenon of mortgage boot and give a couple of examples which can be used to shed light on this issue.
Mortgage Boot Equals Debt Relief
Suppose a client has a rental property which has a $250,000 mortgage loan. For those who own rental properties, this is a very common scenario. Further suppose that the client manages to secure an offer for $600,000. If we omit closing costs, the client would be left with $350,000 following the sale. In this scenario, many clients simply assume that only this remaining $350,000 needs to be spent in order to achieve full tax deferral. While this perception may seem reasonable, it misses the purpose of Section 1031. In this scenario, even if the taxpayer has $350,000 of cash remaining after paying off the mortgage, he or she also has “debt relief” because the mortgage was paid off using capital gains from the sale. In other words, the client has settled the loan by using the gains which are meant to be deferred in the 1031 exchange. If the client was able to simply pay off the mortgage and then achieve full tax deferral by spending the remaining funds, he or she would have a dual benefit not conceived by Sec. 1031.
To achieve full tax deferral, clients have to defer all of the gains realized by the sale. If a client uses proceeds to pay off a mortgage loan, then the amount spent on the loan will need to be recaptured on the purchase side of the transaction. Using the above scenario, the client would need to acquire a new mortgage loan of at least $250,000. Or, the client would need to come in with additional funds from outside the exchange of at least $250,000. Either way, any reduction would constitute debt relief and be taxable to the extent of the gain. Let’s look at a couple of examples.
Suppose a client buys a rental condo for $500,000, and he or she obtains a mortgage loan of $200,000. After 5 years, the rental condo has a value of $1 million, and then mortgage loan has been reduced to a balance of $150,000. When the client goes to conduct an exchange, he or she will have a capital gain of $500,000 if the condo sells for $1 million. But, this $500,000 can only be deferred if the entire gain be deferred. This means that the client will need to acquire a replacement property of at least $1 million. After paying off the mortgage loan, the client will have around $850,000, excluding closing costs. In this type of scenario, you need to counsel clients to acquire a property of at least $1 million, even if this involves acquiring a new mortgage loan. If the client simply spends the $850,000, then the $150,000 mortgage pay off will be treated as debt relief, and debt relief is treated as income for tax purposes. The taxpayer would then be taxed on the $150,000.
Consider another hypothetical scenario. A client buys a rental house for $400,000 and obtains a mortgage loan of $200,000. After 3 years, the rental house doubles in value to $800,000, and the mortgage loan drops to $175,000. If the client sells, he or she will have a gain of $400,000, and available cash of approximately $625,000 (again, not including the closing costs). Suppose this particular client doesn’t want to obtain another mortgage loan. In this scenario, you can counsel the client in one of two ways: (1) bring in additional funds to acquire a replacement property of at least $800,000, or (2) take the tax hit on the debt relief of $175,000. In some cases, clients may be satisfied with a bit of debt relief as long as the majority of the gain be deferred, while others may prefer to bring in additional funds. Everything depends on the needs of your client.
You can use examples such as these to help clients wrap their heads around this issue. This issue isn’t easy to grasp, especially for those with no background in this area. The key is that anything which comes back to the client will be taxable to the extent of the gain, including debt relief (which is equivalent to income from a tax standpoint).
This article was written by Jorgen R. Olson, an independent writer based in Seattle, WA. He writes on behalf of Sammamish Mortgage, a family-owned mortgage company serving clients in the Pacific Northwest region for over 25 years.