Advanced Boot Tax Planning: Installment Notes, OZ Funds and Bonus Depreciation

Case file one: a $3,000,000 sale with $600,000 of boot carried on a five-year seller note

Hypothetical facts: sale price $3,000,000, adjusted basis $1,200,000 after $800,000 of straight-line depreciation on the building, realized gain $1,800,000. The buyer pays $2,400,000 in cash, which goes to the intermediary and into replacement property, and gives a $600,000 note payable over five years. The note is other property, so $600,000 of gain is recognized under §1031(b), and $1,200,000 is deferred.

§453(f)(6) makes the installment method work inside the exchange: the like-kind property received is not a payment, the contract price is reduced to the $600,000 note and the gross profit is the $600,000 recognized, so every dollar of principal is gain as it arrives. The note must be delivered to the intermediary and assigned to you when the exchange ends, because Reg. §1.1031(k)-1(j)(2) treats you as not receiving payment until then.

Two ordering rules decide the rate. Under Reg. §1.453-12(a) unrecaptured §1250 gain, taxed at up to 25%, is taken into account before adjusted net capital gain, so the first $600,000 of principal on this note is 25%-rate gain; and under §453(i), if any of that depreciation had been bonus or cost-segregation deductions on §1245 components, that recapture income is taxed in the year of sale even though not a dollar of principal has been paid.

Case file two: offsetting the same $600,000 with a bonus-depreciation fund

The so-called lazy 1031 skips the note and buys a loss instead. Public Law 119-21 restored a permanent 100% first-year deduction under §168(k) for qualified property acquired after January 19, 2025, as the IRS confirms on its Working Families Tax Cuts business page; a fund that buys buildings, runs a cost segregation study and deducts the short-life components in year one passes that loss to investors, which is the structure behind our accelerated depreciation funds.

The loss only reaches the gain if both are passive. Reg. §1.469-2T(c)(2) treats gain from disposing of a passive activity as passive activity gross income, so a fund loss allocated to you in the year of sale can absorb the $600,000 of boot from a rental you did not materially participate in. Hypothetically, if a fund allocated first-year losses equal to 50% of your investment, offsetting $600,000 would take $1,200,000 of capital; the number varies by offering and is never guaranteed.

Three limits apply. The loss cannot touch wages or portfolio income unless you are a real estate professional under §469(c)(7), with more than 750 hours and more than half your working time in real property trades; the $25,000 allowance in §469(i) phases out between $100,000 and $150,000 of AGI; and the deduction is timing, not forgiveness, because the fund's §1245 components are recaptured as ordinary income when the fund sells, capped in a later exchange by §1245(b)(4) at the gain recognized plus non-§1245 property received.

Case file three: routing the boot into a qualified opportunity fund, and why January 1, 2027 matters

Under §1400Z-2(a) you may elect to defer an eligible gain by investing the gain amount, not the whole proceeds, in a qualified opportunity fund within the 180-day period beginning on the date the gain would be recognized. For $600,000 of boot on a sale closing October 15, 2026, that window runs to April 13, 2027, and the date you fund the QOF now decides how long the deferral lasts.

IRS Notice 2026-40 spells out the split. A qualifying investment made on or before December 31, 2026 must include the deferred gain in the tax year that includes the earlier of an inclusion event or December 31, 2026, so funding in November 2026 defers the $600,000 by a few weeks. An investment made on or after January 1, 2027 includes the gain at the earliest of a sale, another inclusion event or five years from the investment date, with a 10% basis increase after five years, 30% for a qualified rural opportunity fund, and the 10-year exclusion on the fund's own appreciation still available.

The practical move for a late-2026 closing is to hold the boot in cash and fund the QOF in the first quarter of 2027, inside the 180 days. Which gains are eligible and how the 180-day clock runs for exchange boot should be confirmed with your CPA, and the fund choices are compared in 1031 vs opportunity zone funds vs paying the tax.

Where the tools collide: recapture first, interest above $5,000,000, and the passive-loss wall

Layering works until one rule overrides another; these are the collisions that generate the surprise bills.

• §453(i): if you took bonus depreciation or cost segregation on the property you are selling, the §1245 recapture is ordinary income in the year of sale and cannot ride the note; only the gain above it is spread.
• §453A interest: when notes from sales over $150,000 total more than $5,000,000 at year-end, you owe interest on the deferred tax. With $8,000,000 outstanding, the applicable percentage is 37.5%; on $6,000,000 of deferred gain at a 20% rate the deferred tax is $1,200,000, so $450,000 bears interest at the §6621 underpayment rate, the federal short-term rate plus 3 points, roughly $31,500 a year at 7%.
• §453A(d) pledge rule: borrow against the note and the net loan proceeds are treated as a payment received, accelerating the gain.
• §453(e): if the buyer is a related person who resells within two years, the resale proceeds are treated as your payment.
• §469(g): suspended passive losses are released only by a fully taxable disposition to an unrelated party; an exchange is not one, so those losses stay suspended except to the extent the boot gain gives them passive income to absorb.
• §168(k) dates: a fund that acquired its property before January 20, 2025 is limited to the 40% rate for 2025 placements under IRS Notice 2026-11, so ask the sponsor for acquisition dates before counting on 100%.
• QOF mechanics: the investment must be cash into the fund's equity, and if the boot itself is a note rather than cash, timing of the eligible gain follows the installment reporting, which is a question for your CPA before you sign the purchase contract.

A four-year sequence for a high-income seller

The plans that hold up treat each tool as a year in a calendar rather than a menu. Using the $3,000,000 case: year one, exchange $2,400,000 into DST interests and direct property, take the $600,000 as a five-year note, and recognize any §1245 recapture immediately; the recapture is the one bill you cannot move.

Year one also, or year two, place capital in a bonus-depreciation fund sized to the 25%-rate gain arriving on the note, and keep total outstanding notes under $5,000,000 so §453A never applies. If a portion of gain is better parked than offset, fund a QOF on or after January 1, 2027 for the five-year deferral.

Years three to five, the note pays off, the fund's losses have been used against passive income, and the DST interests can be exchanged again when they sell or carried to the estate under swap till you drop planning. We coordinate the DST, bonus-depreciation and opportunity-fund pieces with your CPA, who should sign off on every layer because these rules interact differently on every return.