One of the most esoteric parts of the 1031 tax exchange process is the idea of the "boot" - any additional funds which might be left over from the sale of your original relinquished property after you have purchased your replacement property. When completing a 1031 tax exchange, it is critical that you work to avoid receiving boot in any way, shape or form.

Historically speaking, the term "boot" is an old English term that means "something given in addition to." This is the origin of the current phrase "to boot" - as in "I bought a new cell phone - and the dealer threw in a month of free service to boot." In your 1031 tax exchange, the boot you receive is the cash (or simply fair market value) you are given in exchange for selling your first property. In the simplest situations, this is cash funds - but the boot can also refer to non-cash assets, such as a promissory note, personal property, or a promise of goods or services at a later date.

One of the most common ways for a seller to receive boot is in a "trading down" exchange. This is likely to occur if you sell a relinquished property and purchase a replacement property that is of a lower value. If, for example, you sell a property for $200,000 and purchase one that costs only $150,000, you will have traded down - and you will have a boot in the form of "net cash received." In such a "trading down" exchange, it is also possible to receive a boot in the form of a lesser debt (rather than greater cash). Consider the following example. On your relinquished property, you held a mortgage of $100,000. When you purchased your replacement property, however, the value was lower - and you now have a debt load of just $50,000. By lowering your debt load, you have just acquired a boot.

It is also possible to acquire a boot in a more non-traditional way through the misuse of sale proceeds or excess borrowing. In the first example, the exchanger can find him or herself in trouble if sale proceeds are used to pay non-qualified expenses. This can include costs that arise at real estate closings that are NOT actual closing costs - like utility escrow charges or rent perorations. In the second instance, an exchanger can acquire a boot by borrowing more money than is needed to close on the replacement property (thus providing additional tax-free funds to the exchanger).

When completing a 1031 tax exchange, it is wise to avoid receiving a boot in order to avoid paying unwanted taxes. To avoid receiving a boot, "trade up" in properties and ensure that you are borrowing no more than is necessary to finance the purchase of your replacement property.

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