Mortgage Boot (Debt Relief)

The term comes from the rule that debt relief counts as money received.

The last sentence of section 1031(d) says that where another party to the exchange assumed a liability of the taxpayer, determined under section 357(d), the assumption is treated as money received. Reg. section 1.1031(b)-1(c) treats assumed liabilities as other property or money for section 1031(b), and nets liabilities when each side takes on the other's.

Reg. section 1.1031(k)-1(j)(3), Example 5, applies this to a deferred exchange. The buyer assumed the taxpayer's $30,000 mortgage and the taxpayer assumed a $20,000 mortgage on the replacement; the $10,000 excess was money or other property, and $10,000 of gain was recognized.

The Form 8824 instructions state the netting for line 15: the excess of liabilities assumed by the other party over the liabilities you assumed, the cash you paid and the value of other property you gave up. Publication 551 confirms that in a deferred exchange, liabilities paid off on the property given up count as relief, and new debt incurred on the replacement counts against it.

In a hypothetical exchange, a smaller loan on the replacement creates boot with no cash in hand.

Hypothetically, you sell for $1,000,000, a $400,000 mortgage is paid off at closing, and your basis is $300,000. The intermediary holds $600,000, and you buy a $900,000 replacement with that money and a $300,000 loan. Debt relief of $400,000 minus $300,000 of new debt leaves $100,000 of mortgage boot, and $100,000 of your $700,000 realized gain is recognized.

Had you bought a $1,000,000 replacement with the $600,000, $100,000 of your own cash and a $300,000 loan, the added cash would offset the remaining relief and no gain would be recognized. Costs are ignored here; run your own numbers with your CPA.

In the first version, the replacement's basis under section 1031(d) is $300,000: the old $300,000 basis, less the $400,000 of debt relief treated as money received, plus the $300,000 of new debt, plus the $100,000 of gain recognized. That equals the $900,000 value minus the $600,000 still deferred.

It bites when owners deleverage, and the netting only runs one way.

Reg. section 1.1031(d)-2, Example 2, sets the direction: cash or other property you give offsets debt relief, but cash you receive is not offset by debt you assume. So a larger loan cannot cover cash taken out; see whether more debt offsets cash taken out.

If you want less leverage, the choice is between adding cash and accepting some boot; replace the mortgage or add cash walks through it. For a fractional replacement, see whether a DST loan counts as replacement debt.