Many 1031 exchangers think of "boot" as money proceeds from selling a relinquished property that is not reinvested in the replacement property. Often this occurs because the investor has another use for some of the proceeds and is willing to incur the taxes on the amount not reinvested.
Other times, boot can occur because an investor cannot find a suitable replacement property to invest the entire proceeds. As you remember, the 1031 exchange requires the investor to find a replacement property of “equal or greater” value in order to defer taxes entirely.
An example of this ‘involuntary boot’ situation would be if you sold your rental duplex for $800,000 and found a suitable replacement property you liked, but the purchase price was only $700,000. You recognize that the $100,000 in boot is not enough to purchase another replacement property, so you would be responsible for paying capital gains tax on the uninvested $100,000.
If you find yourself in this situation, there is a backup plan that could save your exchange from taxation. If suitable, the Delaware Statutory Trust or DST is a great option.
Kick the Boot
A DST is an investment structure that meets 1031 exchange “like-kind” property requirements. It has become increasingly popular among investors looking to shed the hassles of actively managing investment property while they still desire to own income-producing real estate. A DST is a passive investment where investors own fractional shares in a property or properties that are managed by professional management companies.
The advantage a DST offers you if you are facing boot in your exchange is the ability to invest a relatively small amount of money – sometimes evan as little as $10,000 – in high-quality institutional property that meets 1031 exchange replacement property requirements.
The DST Backup
You can also help relieve yourself from boot in your exchange by selecting a DST as one of your potential replacement properties. Remember, you can choose more than one replacement property during your 45-day identification period. Should you close on your desired replacement property and recognize you will have boot, your backup DST can still allow you to complete a full exchange with complete tax deferral successfully.
As mentioned, there are instances when 1031 exchange investors may select to receive a portion of their sale proceeds in cash and pay the tax. However, for other cases where the investor is challenged to find a suitable property to invest the total proceeds and defer their tax liability, the DST has proven to be an effective backup plan!