Boot Netting: Cash Cures Debt, But Debt Never Cures Cash

Most investors learn two separate rules about boot: cash you receive is taxable, and debt relief is taxable. What they are rarely told is how the two interact.

They are netted, but not symmetrically. One can offset the other, and the reverse is not true. That asymmetry determines whether an otherwise well structured exchange produces a tax bill.

What is netting?

Boot is calculated on a net basis rather than counting every movement separately. The question is what value you ended up receiving overall, not how many line items appear on a settlement statement.

Two categories matter: cash boot, meaning money or other non like kind property received, and mortgage boot, meaning relief from debt.

What is the one way rule?

Adding cash cures debt relief. If the replacement property carries less debt than the relinquished property, you can offset the shortfall by contributing additional cash of your own to the purchase. The debt relief is neutralised.

Taking on debt does not cure cash received. If you take cash out of the exchange, borrowing more on the replacement property does not offset it. The cash remains taxable.

The logic is that cash in your pocket is unambiguously value received. Additional borrowing is not a substitute for reinvesting the proceeds.

Can you see it with numbers?

Case one. You sell for 1 million dollars with a 400,000 dollar mortgage, and buy for 1 million dollars with a 250,000 dollar mortgage, adding 150,000 dollars of your own cash. Debt relief is 150,000 dollars, and the cash you added is 150,000 dollars. They offset. No boot.

Case two. You sell for 1 million dollars with a 400,000 dollar mortgage, and buy for 900,000 dollars with a 500,000 dollar mortgage, taking 100,000 dollars of cash at closing. You took on 100,000 dollars more debt, but you also received 100,000 dollars of cash. The extra debt does not cure the cash. You have 100,000 dollars of cash boot.

Case three. You sell for 1 million dollars with a 400,000 dollar mortgage, and buy for 1.1 million dollars with a 600,000 dollar mortgage. Debt increased and no cash was received. No boot.

Does it matter which type of boot is taxed?

Not for the rate. Boot of either kind is taxable to the extent of your realised gain, and on a long held property it is generally applied against unrecaptured depreciation first, at up to 25 percent federally, before long term capital gains rates.

What differs is how fixable each is before closing. Debt shortfalls can be cured with cash. Cash received cannot be cured at all.

Where does unintended boot come from?

• ›Cash back to the seller at closing
• ›Prorated rents and security deposits transferred to you
• ›Non transaction expenses paid from exchange funds
• ›Buying a cheaper replacement property
• ›Paying off a mortgage and buying with less leverage
• ›Receiving personal property along with the real estate

Most of these are visible on a draft settlement statement, which is why having your intermediary review it before closing matters.

How do you plan for it?

Work out three numbers before you sell:

• ›Net proceeds that must be reinvested
• ›Debt that must be replaced
• ›Outside cash you are willing to contribute if the replacement carries less debt

If you know the third number in advance, a debt shortfall becomes a decision rather than a surprise.

What if you want to reduce leverage deliberately?

Many owners do, particularly approaching retirement. The clean way is to contribute outside cash equal to the reduction, so no boot arises. The alternative is to accept the debt relief as boot and pay tax on it, which is a legitimate choice if you understand the cost.

Does the timing of cash and debt matter?

Yes. Netting is generally applied across the exchange as a whole, but the way a transaction is documented can affect the result.

Cash contributed at the replacement closing is straightforward. Cash spent elsewhere, or debt paid down outside the transaction, may not produce the offset you expect. If you intend to add money to cure a debt shortfall, the cleanest route is to bring it to the replacement closing so it appears on the settlement statement as part of the purchase.

What about several relinquished or replacement properties?

When an exchange involves more than one property on either side, all the values, proceeds and debts are combined for the calculation. You do not need each replacement to match each relinquished property individually. What matters is the total value acquired, the total proceeds reinvested and the total debt replaced across the exchange.

That gives useful flexibility. A replacement with heavy leverage can offset a debt shortfall on another, provided the totals work out.

What to do first

Ask your CPA to calculate expected boot from the draft numbers before either closing, showing cash and debt separately and then netted. If the calculation shows a debt shortfall, decide early whether to add cash, choose a replacement with more leverage, or accept the tax.

Nothing here is tax, legal or investment advice. Confirm your calculations with your CPA before closing.