Boot

The word boot appears nowhere in the Code. It is practitioners' shorthand for what section 1031(b) calls money and other property, and the recognition it triggers is the ordinary outcome rather than the exceptional one. Complete deferral requires a taxpayer to reinvest everything, and most taxpayers do not.

This chapter establishes what counts as boot, how much gain it causes to be recognized, how the offsetting rules work, what rate applies to the result, and how transaction costs are treated.

33.1 Taxonomy: cash, other property, and net debt relief

The statutory rule is short. If an exchange would be within section 1031(a) except that the property received consists not only of like-kind property but also of other property or money, then the gain to the recipient is recognized, but in an amount not in excess of the sum of that money and the fair market value of that other property.¹

The companion provision is shorter and less forgiving. Where an exchange would be within section 1031(a) except for the receipt of other property or money, no loss from the exchange is recognized.²

Boot therefore causes gain to be recognized and does nothing whatever for a taxpayer holding a loss. A taxpayer whose property has declined in value should ordinarily sell rather than exchange, because the exchange preserves a loss in basis that a sale would allow immediately, and the point is developed at 9.2.

Three categories of consideration constitute boot.

Cash. Money received by the taxpayer, in whatever form and from whatever source within the transaction.

Other property. Property received that is not of a like kind, taken into account at its fair market value. After 2017 this category is larger than it was, because all personal property received in a real property exchange is other property.

Net debt relief. The third category is the one that produces surprises, because no money changes hands. For purposes of the basis rules, the amount of any liabilities of the taxpayer assumed by the other party to the exchange, or of any liabilities to which the property exchanged by the taxpayer is subject, is treated as money received by the taxpayer upon the exchange, whether or not the assumption resulted in a recognition of gain or loss.³

The statute states the same rule and supplies a definitional cross-reference that repays attention. Where, as part of the consideration to the taxpayer, another party to the exchange assumed a liability of the taxpayer, as determined under section 357(d), the assumption is considered money received by the taxpayer on the exchange.⁴

Section 357(d) supplies the mechanics of assumption, and its two branches differ.⁵

A recourse liability, or a portion of one, is treated as having been assumed if, on the basis of all facts and circumstances, the transferee has agreed to and is expected to satisfy it, whether or not the transferor has been relieved of it. Formal release is therefore not the test, and a taxpayer who remains liable on paper may nonetheless be treated as relieved.

A nonrecourse liability is treated as having been assumed by the transferee of any asset subject to it. Where another person owns other assets subject to the same liability and has agreed with the transferee to satisfy part of it, the amount treated as assumed is reduced by the lesser of the amount that person has agreed to and is expected to satisfy, or the fair market value of those other assets.

One technical point deserves notice because it is a common misreading. Section 357(d) states that it applies for purposes of a list of provisions that does not include section 1031. It reaches exchanges because section 1031(d) imports it by express cross-reference, not because section 357(d) reaches out on its own.

33.2 The recognition ceiling

Section 1031(b) recognizes gain "but in an amount not in excess of" the boot received.⁶ That phrase creates a ceiling rather than a rule of inclusion, and the computation therefore involves two numbers of which the smaller controls.

The first ceiling is the gain realized. This is computed on ordinary principles: the amount realized, counting every item of consideration including debt relief, less the adjusted basis of the property transferred. Section 1031 never causes a taxpayer to recognize more gain than the taxpayer actually has.

The second ceiling is the boot received, as 33.1 defines it.

The gain recognized is the lesser of the two. The regulation's simplest illustration makes the point in one line. A taxpayer exchanged investment real estate purchased for $5,000 for other real estate worth $6,000 plus $2,000 in cash. The gain from the transaction was $3,000, and it was recognized only to the extent of the $2,000 of cash received.⁷

The reverse case is equally important and is the one clients find counterintuitive. A taxpayer with $50,000 of realized gain who receives $200,000 of boot recognizes $50,000, not $200,000. Boot in excess of gain has no consequence, because there is no more gain to recognize.

A worked example from the liability regulation shows the ceiling operating with debt in the computation. A taxpayer owned an apartment house with an adjusted basis of $500,000, subject to a $150,000 mortgage, and transferred it subject to that mortgage in exchange for $50,000 in cash and another apartment house worth $600,000. The total consideration received was $800,000, being the $600,000 of property, the $50,000 of cash, and the $150,000 of debt relief. Against a $500,000 basis, the gain realized was $300,000. The boot was $200,000, being the cash plus the debt relief, and $200,000 of the $300,000 gain was recognized.⁸

The intuition worth giving a client is that the taxpayer is taxed on the smaller of what was gained and what was taken off the table.

33.3 Netting and the offsetting rules

Boot is computed net, and the netting rule is asymmetric. It is the single most important computational rule in this Part, and the regulation states it in a parenthetical inside an example, which is why so many practitioners have never read it.

Although consideration received in the form of cash or other property is not offset by consideration given in the form of an assumption of liabilities or a receipt of property subject to a liability, consideration given in the form of cash or other property is offset against consideration received in the form of an assumption of liabilities or a transfer of property subject to a liability.⁹

Stated as two rules:

Cash paid offsets debt relief. A taxpayer relieved of a mortgage may cure the resulting boot by contributing cash to the exchange.

Debt assumed does not offset cash received. A taxpayer who takes cash out cannot cure the resulting boot by borrowing more on the replacement property.

The asymmetry is deliberate and it is economically sensible. Cash in the taxpayer's pocket is realized value regardless of what the taxpayer's balance sheet looks like afterward.

The regulation's second example works both sides of a single transaction and is worth following in full, because seeing the two computations together is what makes the rule stick.¹⁰

D owns an apartment house with an adjusted basis of $100,000, a fair market value of $220,000, and an $80,000 mortgage. E owns an apartment house with an adjusted basis of $175,000, a fair market value of $250,000, and a $150,000 mortgage. D transfers its property to E and receives E's property plus $40,000 in cash. Each property is transferred subject to its own mortgage.

D's computation. D received $250,000 of property, $40,000 of cash, and $80,000 of debt relief, for total consideration of $370,000. Against that, D had a $100,000 basis and assumed $150,000 of debt, or $250,000. D's gain realized was $120,000.

D's boot is $40,000. The $80,000 of debt relief is fully offset by the $150,000 of debt assumed, and the excess debt assumed does nothing further, because it cannot offset the cash. Only the $40,000 of cash is boot, and $40,000 of the $120,000 gain is recognized.

E's computation. E received $220,000 of property and $150,000 of debt relief, for total consideration of $370,000. Against that, E had a $175,000 basis, paid $40,000 of cash, and assumed $80,000 of debt, or $295,000. E's gain realized was $75,000.

E's boot is $30,000. The $150,000 of debt relief is offset by the $80,000 of debt assumed and by the $40,000 of cash E paid, a total of $120,000, leaving $30,000. That $30,000 of the $75,000 gain is recognized.

E's side is the demonstration. Cash paid worked as an offset against debt relief. Had the amounts been reversed, so that E received $40,000 of cash and assumed more debt, the cash would have been boot and the extra debt would not have helped.

The Service administers the rule in exactly these terms. The return instructions direct the taxpayer to include in boot any cash received, the fair market value of non-like-kind property received, and the excess, if any, of liabilities assumed by the other party over the total of liabilities the taxpayer assumed, cash the taxpayer paid, and the fair market value of non-like-kind property the taxpayer gave up.¹¹

33.4 Character of gain recognized

Section 1031(b) determines how much gain is recognized. It says nothing about what kind of gain it is, and the answer is frequently worse than the client expects.

The recognized gain carries the character it would have had on a taxable disposition, determined under the ordinary characterization provisions. Three possibilities arise in a real property exchange, and they are taxed at materially different rates.

Ordinary income from recapture. Where the relinquished property includes section 1245 property, the recapture provision applies before the capital gain provisions, subject to a ceiling of its own. If property is disposed of and gain, determined without regard to section 1245, is not recognized in whole or in part under section 1031, the amount of gain taken into account as recapture shall not exceed the sum of the gain recognized on the disposition, determined without regard to section 1245, plus the fair market value of property acquired which is not section 1245 property and which is not taken into account under the first component.¹²

The practical effect is that recapture cannot exceed the recognized gain, but within the recognized gain it comes first. Boot gain is ordinary to the extent of recapture potential, and only the remainder is capital.

A parallel limitation governs section 1250 property, expressed as the greater of the gain recognized, adjusted as the statute provides, and an amount computed where insufficient section 1250 property is acquired.¹³

Unrecaptured section 1250 gain. Real property that has been depreciated generates gain attributable to that depreciation which, although capital, is taxed at a maximum rate of twenty five percent rather than at the long term capital gain rate. For a building held many years, this component is often the largest.

Long term capital gain. The remainder.

Two further charges may apply to the recognized amount. The net investment income tax reaches gain from the disposition of property held in a passive activity or otherwise within its scope. And State income tax applies on its own terms, which for a taxpayer exchanging out of one State into another raises the sourcing and clawback questions taken up in Part XI.

The counsel is arithmetical rather than doctrinal. A client told that a small amount of boot will be taxed at capital gain rates has often been told something false. The blended rate on recognized gain in a long held depreciated building can approach ordinary rates, and it should be computed before the client decides to take the cash. Chapter 37 develops the recapture computation.

33.5 Transactional expenses and their treatment

Two different questions are asked about closing costs, and they are constantly confused.

The first question is whether paying them from exchange funds breaks a safe harbor. It does not, for the items the regulation describes. In determining whether a safe harbor has ceased to apply and whether the taxpayer's rights are expressly limited, the taxpayer's receipt of or right to receive transactional items is disregarded, meaning items that relate to the disposition of the relinquished property or the acquisition of the replacement property and that appear under local standards in the typical closing statements as the responsibility of a buyer or seller. The regulation names commissions, prorated taxes, recording or transfer taxes, and title company fees.¹⁴ Items a seller may receive that are not included in the amount realized, such as prorated rents, are separately disregarded.¹⁵

The second question is what effect the expenses have on the computation, and the regulation just quoted does not answer it. The Service's administrative position is stated in the return instructions and is straightforward.

Exchange expenses reduce the boot, but not below zero.¹⁶ To the extent they are not used for that purpose, they are added to the adjusted basis of the property given up in computing the realized gain.¹⁷

An expense therefore does one of two jobs and never both. Where the taxpayer has boot, the expense reduces it dollar for dollar, which is the more valuable outcome because it reduces recognized gain immediately. Where the taxpayer has no boot, the expense reduces realized gain, which is deferred into basis in the manner Chapter 35 develops.

The line that matters is what counts as an exchange expense. The regulation's description reaches items appearing in a typical closing statement as the responsibility of a buyer or seller. Two categories sit outside that description and should be analyzed rather than assumed.

Financing costs, including loan origination fees, points, lender required appraisals, and mortgage insurance, relate to the taxpayer's borrowing rather than to the disposition or acquisition of the property. They are ordinarily treated as costs of obtaining the loan, with their own recovery rules, and paying them from exchange funds is not within the regulation's list.

Operating items that benefit the taxpayer personally, including prepaid insurance, utility deposits, prorated rent credited to the taxpayer, and security deposits transferred, are not costs of the disposition or acquisition. Prorated rents are separately disregarded for safe harbor purposes, but that disregard concerns the harbor and not the computation.

Two practical instructions follow, and both are cheap.

Have the settlement statement categorize each line item before closing rather than after, and have the intermediary confirm which items it will fund. A disagreement discovered at the closing table is resolved by whoever is in a hurry.

Where a doubtful item is material, the conservative course is for the taxpayer to pay it from outside funds. Cash the taxpayer contributes to the exchange offsets debt relief under 33.3, so outside payment of a questionable item is rarely wasted and often helpful.