Partial 1031 Exchange: How to Take Some Cash Out and Defer the Rest

How boot is taxed

In a partial exchange you recognize gain equal to the lesser of your realized gain or the boot you receive (IRC §1031(b)). Boot is cash received plus net debt relief (mortgage paid off minus mortgage taken on, minus new cash you put in) plus any non-real-estate property. The reinvested portion defers exactly as it would in a full exchange.

The ordering matters. The IRS treats recognized gain as coming first from unrecaptured §1250 gain (the depreciation portion, taxed at up to 25%) and only then from the capital gain taxed at 15% or 20%. Taking $100,000 of cash out of a sale with $139,000 of accumulated depreciation means the whole $100,000 is taxed at the 25% rate, plus state and the 3.8% NIIT. Full boot rules here.

A worked example

You sell a rental for $700,000 net with $439,000 of total gain (of which $139,000 is depreciation). You buy a $600,000 replacement and keep $100,000 in cash.

• Boot: $100,000 (cash) plus any net debt relief
• Recognized gain: $100,000, taxed as recapture at 25% federal ≈ $25,000, plus 3.8% NIIT and state
• Deferred gain: $339,000, carried into the new property

Roughly a third of the cash you took out goes to tax. That's still far better than a fully taxable sale, and it's the honest price of liquidity through the exchange.

When the cash can legally be released

This is where partial exchanges go wrong. Under Treas. Reg. §1.1031(k)-1(g)(6), once funds are in the exchange account the QI may release them to you only:

1. At the closing of your sale, if you instruct the closing agent to pay a stated amount directly to you and send only the balance to the QI. This is the cleanest way to take boot.
2. After day 45, if you have not identified any replacement property, or if you've acquired every property you identified.
3. After day 180, or when the exchange is complete.

The QI cannot release funds on day 90 because you 'changed your mind about how much to reinvest.' Attempting it can taint the whole exchange as constructive receipt. Decide the cash amount before closing.

The often-better alternative: refinance after

Loan proceeds aren't income. If you complete a full exchange and then, once the dust settles, do a cash-out refinance on the replacement property, you have liquidity with no boot and the full gain still deferred. The timing has to be respected: a refinance pre-arranged as part of the exchange closing invites the IRS to treat it as a disguised cash-out. Waiting a reasonable period and having a real business reason is the accepted practice. Details in refinancing after a 1031 exchange.

Trading down is also a partial exchange

Buying a cheaper replacement without taking cash still produces boot, because the difference between what you sold and what you bought is treated as value not reinvested. The trade-down rules cover how to compute it and how a second property or a DST slice can close the gap.