What Year is “Boot” Taxable in a 1031 Exchange?

Boot is the term that the IRS uses for the part of an exchange that is taxable. Boot generally arises for one of two reasons: the Seller bought down, or the seller did not reinvest all of the cash from the sale of Old Property. Most of the year, it doesn't matter what caused the boot: it's simply taxable. But when a transaction overlaps the end of the year, the year of taxability becomes important.

Suppose Fred and Sue sold their purple duplex on December 20, 2005, for $100,000 and bought their New Property on March 1, 2006. At the time of the sale, they paid off the mortgage of $40,000 from their lender, leaving a balance of $60,000 that went to their intermediary. Let's say they bought their New Property for $90,000 (they bought down), property they paid for with a new mortgage of $40,000 and $50,000 in cash from the intermediary. This leaves $10,000 in unspent proceeds that are returned to them by their intermediary shortly after the purchase. Is the $10,000 taxable in 2005 when they sold the purple duplex or in 2006 when they bought the New Property? With the exception of the impact that depreciation recapture might have on their exchange, the answer is 2006 when they actually received the cash. In a 1031 exchange, this “cash boot” (boot caused by receipt of cash) is subject to the installment sale rules which mean that the proceeds are taxed when they are received. And yes, the entire $10,000 is taxable.

...Most of the year it doesn't matter; but when it overlaps years, it becomes important...

In their 2005 tax return (the year of the sale) Fred and Sue would report the exchange on Form 8824 (Like-Kind Exchanges form), and they would report the cash that got deferred until 2006 on Form 6252 (Installment Income Sale form). In their 2006 return, they would file another Form 6252 showing the receipt and taxability of the $10,000 from the prior year's sale.

Now let’s change our facts slightly and see what happens. As in the example above, they sold their purple duplex on December 20, 2005, for $100,000; and on March 1, 2006, they bought the New Property for $90,000, using the $60,000 held by the intermediary and getting a $30,000 loan for the balance. And, as in the previous example, they bought down by $10,000, but in this example they used all the cash. In this case is the $10,000 buy down taxable in 2005 when they sold the purple duplex or in 2006 when they bought the New Property? The answer is 2005 (when they sold the duplex) because the $10,000 buy down is “debt boot” (boot caused by debt reduction) instead of “cash boot.” Here’s the reason: when they sold the purple duplex for $100,000 they used $40,000 to pay off the mortgage on the duplex, and when they bought their New Property they had $60,000 in cash and only needed a new mortgage of $30,000 for the purchase. In effect they received the excess cash at the time of the sale, which is why it is taxable in 2005.

Be careful when you have “cash boot” that would be taxable in the subsequent year that you consider depreciation recapture. Working through the items on Form 6252, you’ll discover that depreciation recapture is taxable in the year of the sale up to the amount of the taxable gain. In our example in which Fred and Sue received the excess cash of $10,000 in the subsequent year (2006), they would report depreciation recapture, up to that amount, in 2005 (the year of the sale). If they had taken $2,500 in depreciation prior to the sale, then $2,500 would be taxable in 2005, and the balance ($7,500) would be taxable in 2006.