If you’re not careful, rolling over investment property can leave you with an unexpected tax bill.
A lot of lucky folks are holding real estate and other types of investment property with fair market values greater than their adjusted bases. Some of these folks want to roll over their holdings (say, from old buildings to shiny new ones), not to reap any gain but just to continue their investments in different forms. Internal Revenue Code §1031 makes it possible for them to do that and at the same time avoid immediately paying any tax by deferring the gain until a time, perhaps years later, when the new property is sold. Cool.
But be warned: there are devils lurking in the details. One is called “boot” and the other “recapture income”. They can both really kick the bejeebers out of all your happy plans.
For a like-kind swap to work the parties must end up with as much equity as they started with (at least in their own minds). But in the real world the chance of finding counterparties with exactly matching equities is slim to none. So to even things out someone has to sweeten the pot, has to chip in extra cash or assume some debt or hand over title to other, non-like kind property. And that sort of stuff, in a nutshell, is called boot.
So here’s the kicker: If you receive boot in a §1031 like-kind exchange it’s immediately taxed, up to a maximum of your realized gain on the deal. Let’s see how this plays out in an example.
Suppose that ten years ago Alice took out a mortgage and purchased a rental property for $100,000. Since then she’s dutifully taken depreciation deductions of $3,500 per year (total $35,000), leaving her an adjusted basis of $65,000. Today the fair market value of her property is $150,000 and she still owes $50,000 on the mortgage.
Across town Bill owns a different rental property worth $90,000, which he bought years ago for $60,000. There is no outstanding debt on Bill’s land.
If they simply sold their properties outright Alice would realize an $85,000 gain ($150,000 – $65,000), and Bill $30,000 ($90,000 – $60,000). Both would get hit for taxes and only the leftover would be available for reinvestment. Lucky for them both, Bill wants Alice’s property and she wants his.
So instead of selling their properties they enter into a §1031 like-kind exchange. Bill takes Alice’s rental property and assumes her debt (Bill’s total equity received = $150,000 – $50,000 = $100,000). Alice takes Bill’s property and, to even things up, Bill pays her another $10,000 in cash (Alice’s total equity received = $90,000 + $10,000 = $100,000).
Now Alice has the property she wanted and goes into year-end ready to defer the gain she would otherwise have had to recognize. Let’s see how she actually makes out on this deal.
Right away note that Alice must recognize immediately as “recapture income” the $35,000 of depreciation deductions previously taken. No deferral here. Worse still, she has to pay the ordinary income tax rate, not the lower capital gains rate, on it. Yikes.
And then there’s the boot Alice received. Bill paid her $10,000 in cash (“cash boot”) and also assumed her remaining $50,000 loan balance (“mortgage boot”). In a §1031 exchange, the smaller of the realized gain ($85,000) and the total boot received ($60,000) is immediately taxable. Double yikes.
There’s a bit of good news for Alice: The $60,000 of boot gets offset by the recapture income. So in the end she’ll pay capital gains tax on just $25,000 ($60,000 – $35,000) of this boot.
The bottom line? Of Alice’s $85,000 in “realized gain” on this swap she only gets to shield $25,000 from immediate taxation. Without a single dollar’s increase to equity on her balance sheet, Alice gets a tax bill on the remaining $60,000 of gain, more than half of it taxed as ordinary income.
That’s not close to what she expected, and it’s not what the hype surrounding like-kind exchanges promises.
With a bit of advice and planning Alice could have improved this result quite a bit. Like-kind exchanges are tricky and anyone contemplating one should consult early and often with a tax professional.
 The word comes from the Old English bot, which meant “a making better” and referred to profit, help, or relief.
This article is for informational purposes only and does not constitute legal advice. You should consult a qualified attorney before taking any action.