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What is the Boot Test?
A "boot" is one of the biggest pitfalls associated with a 1031 tax exchange. Under the rules of a 1031 tax exchange, only real property held for business or investment can be exchanged. There are a number of things that, if included in the exchange, can trigger a substantial capital gains tax bill. "Boot" is anything that is in the trade that is not like-kind property.
The most common types of boot are mortgage boot and cash boot. Mortgage boot becomes an issue when the mortgage debt on the property you buy is less than the mortgage debt on the property you are selling. Similarly, cash boot reflects any cash or other value received that is not real estate investment property, including a promissory note.
There are legitimate ways around "boots," but it makes sense to conduct a "boot" test prior to choosing an exchange property. In conducting a boot test, one must compare the two properties being exchanged and, specifically, the sale/purchase price, mortgage owed and equity. Here are some sample boot tests with different results:
Boot Test #1
Sale Price (Property Sold) $200,000 --- (New Purchase) $225,000
Mortgage Owed (Property Sold) $100,000 --- (New Purchase) $125,000
Your Equity $100,000 (Property Sold) --- (New Purchase) $100,000
This example depicts a fully tax deferred exchange. The new mortgage balance on the purchased property is of equal or greater value, and the equity has moved across.
Boot Test #2
Sale Price (Property Sold) $200,000 --- (New Purchase) $225,000
Mortgage Owed (Property Sold) $100,000 --- (New Purchase) $175,000
Your Equity $100,000 (Property Sold) --- (New Purchase) $50,000
In this example there would be taxable boot. All of the equity is not used in acquiring another "like-kind" property. Any cash the exchanger puts into his pocket would be taxable as "boot" by the Internal Revenue Service (In this case, that figure is $50,000).
Boot Test #3
Sale Price (Property Sold) $200,000 --- (New Purchase) $175,000
Mortgage Owed (Property Sold) $100,000 --- (New Purchase) $75,000
Your Equity $100,000 (Property Sold) --- (New Purchase) $100,000
In this example there would also be taxable boot. A property of less value was purchased, and there is a new mortgage of less value than the mortgage on the relinquished property. The difference between the two mortgages is classified as "mortgage relief," and is taxable as boot (in this case, $25,000).
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What is the Boot Test?