The CFP® exam tests you on a broad variety of topics. One general category that seems to weave its way into a lot of questions is income tax. As you progress with your CFP® exam prep, you’ll notice that a lot of practice exam questions have a tax “wrapper.” In other words, a question from general principles or investments or estate planning might ask have a tax-related angle to it, even though the question is from one of those aforementioned categories. However, many questions on the Certified Financial Planner™ exam are purely tax-related questions, and a 1031 exchange is one of those topics surely to be tested.
What is a 1031 exchange?
A 1031 exchange is a transaction that allows a real estate investor to exchange their property for a new property and defer any capital gains on the property that is exchanged. The capital gains on this type of like-kind exchange can be deferred indefinitely.
What is boot?
Boot is property received in a 1031 exchange that is anything other than “like kind” proporty. Boot can be in the form of cash, personal property, or a reduction in the amount of mortgage debt. Boot received in the exchange will be subject to taxes.
The two main types of boot that can result from a 1031 exchange include:
- Cash boot. As an example, if the property being sold or exchanged is worth $400,000 and the property received in exchange is only worth $325,000 then the $75,000 of cash received by the owner of the property being exchanged will have received $75,000 in cash boot.
- Debt reduction or mortgage boot. This occurs when the property exchange results in a lower mortgage debt amount for you. For example:
- Property A is worth $500,000 with a mortgage of $300,000
- Property B is worth $400,000 with a mortgage balance of $200,000
If an investor exchanges property A for property B, then the investor will have received mortgage boot in this exchange in the form of reduced mortgage debt.
Boot can also come about if some of the sales proceeds are used to cover expenses other than closing costs. Examples of these types of costs include:
- Rent prorations
- Damage deposits from tenants transferred to the original owner
- Other costs not related to the closing
To the extent that you receive boot from the exchange of the original property, this amount could be taxable to you.