The Gain You Could Not Defer: What to Do With 1031 Boot

Not every exchange defers everything. Proceeds come in awkward amounts, replacement property is priced where it is priced, and debt rarely matches exactly. The result is boot: a slice of recognised gain in a transaction that otherwise worked.

Most owners treat that slice as settled and pay the tax. There is sometimes another option, because recognised capital gain can be reinvested into a qualified opportunity fund.

What exactly is boot?

Value received in an exchange that is not like kind property. It comes as cash left over after buying replacement property, or as relief from debt that was not replaced.

Boot is taxable in the year of the exchange, limited to your realised gain. On a long held property, it is generally taxed against unrecaptured depreciation first, at up to 25 percent federally, plus state tax and often the net investment income tax.

Why might an opportunity fund be relevant?

Because opportunity zone rules work on gain rather than on total proceeds.

A 1031 exchange requires reinvestment of all net proceeds and replacement of all debt. An opportunity zone investment generally requires only the gain to be invested, within a defined period, into a qualified opportunity fund.

Boot is recognised gain. Where it is eligible gain under the opportunity zone rules, it may be capable of being invested in a fund and deferred under those rules instead of taxed immediately.

What are the conditions?

Several, and they need checking against current law:

• ›The gain must be of a type eligible for opportunity zone treatment
• ›The investment must be made into a qualified opportunity fund within the required period, generally 180 days, with the start date depending on how the gain arises
• ›The benefits depend on how long the fund investment is held

Opportunity zone rules have been revised by recent legislation, including changes affecting new investments. Anything written even a year or two ago may be out of date, so the current rules for your investment date need confirming.

What are the trade offs?

Deferral versus exclusion. A 1031 exchange defers gain and can be repeated indefinitely, with a basis reset at death potentially eliminating it. An opportunity zone investment defers the original gain and, after a long hold, can allow appreciation on the fund investment itself to escape tax.

Control. In a 1031 you choose the property. In a fund, the manager chooses.

Liquidity. Opportunity funds are generally illiquid and designed for long holds.

Complexity. Two sets of rules, two sets of deadlines and two sets of reporting on one sale.

When is it worth considering?

When the boot is large enough to justify the complexity. On 20,000 dollars of boot it rarely is. On 400,000 dollars, where the tax might be 100,000 dollars or more, it can be.

It is also worth considering when boot was unavoidable, for example where the replacement market simply did not offer enough suitable property inside 45 days, or where debt could not be replaced on acceptable terms.

When is it not worth it?

When you would not want the underlying investment on its merits. Tax treatment does not rescue a poor investment, and opportunity funds vary widely in quality, fees and strategy.

It is also unsuitable if you may need the capital, because these are long term commitments.

What are the practical steps?

• ›Calculate the expected boot before closing rather than after
• ›Ask your CPA whether that gain is eligible and when the investment window starts
• ›Evaluate any fund as an investment first
• ›Confirm state treatment, because not every state conforms to the federal opportunity zone rules
• ›Keep the two transactions clearly documented and separately reported

Is there a simpler alternative?

Often, yes. Boot can frequently be avoided rather than managed. A fractional replacement interest, such as a Delaware Statutory Trust, can be subscribed in a precise dollar amount, so an awkward remainder that no building will absorb is reinvested rather than taxed. Adding outside cash can cure a debt shortfall. Both are simpler than running two tax regimes on one sale.

What to do first

Before your exchange closes, ask your CPA for the expected boot figure and the tax on it. If the number is small, plan to pay it. If it is large, ask whether a fractional replacement could absorb it inside the exchange, and only then look at whether an opportunity fund is a sensible home for gain that genuinely cannot be deferred.

Nothing here is tax, legal or investment advice. Opportunity zone rules change and depend on your circumstances. Funds and DST interests are securities with risk including loss of principal. Confirm your plan with your advisers.