A partial 1031 exchange is one where you reinvest most of your sale proceeds in replacement property and keep the rest as cash. The cash is taxable, and the rest of your gain stays deferred, as long as the exchange otherwise follows the rules.
The cash is generally taxed first at up to 25%, the rate for gain from past depreciation. Whether that's worth it depends on what the cash is for.
What makes an exchange partial
Section 1031(b) says that when you receive money or other property along with like-kind real estate, you recognize gain up to its value, and the rest stays deferred. That money or property is boot.
Boot comes from cash you take and from debt relief you don't replace, since Section 1031(d) and its regulations treat a mortgage paid off at your sale as money you received. A planned partial exchange usually means cash. Unreplaced debt is how people end up with one by accident.
How the taxable part is figured
You recognize the lesser of the boot you received or your total gain. This illustrative example ignores closing costs and exchange expenses.
You sell a rental for $600,000. Your adjusted basis is $300,000, after $80,000 of depreciation. At closing, $200,000 pays off your mortgage, $100,000 comes to you as cash, and $300,000 goes to your QI. You then buy a $500,000 replacement property with the $300,000 from the QI and a new $200,000 loan.
| Step | Amount |
|---|---|
| Sale price | $600,000 |
| Adjusted basis | $300,000 |
| Realized gain | $300,000 |
| Cash boot | $100,000 |
| Mortgage boot ($200,000 paid off, $200,000 new loan) | $0 |
| Recognized gain (lesser of $100,000 boot and $300,000 gain) | $100,000 |
| Deferred gain | $200,000 |
| Basis in the new rental ($500,000 price minus $200,000 deferred) | $300,000 |
The exchange and the boot go on Form 8824.
The depreciation part is taxed first, at up to 25%
The tax code defines unrecaptured section 1250 gain as the gain that would be ordinary income if all depreciation were recaptured, and it caps the rate on that gain at 25%. In a like-kind exchange where you buy enough depreciable real property, Section 1250(d)(4) generally limits that amount to the gain you recognize. Read together, recognized gain on a depreciated rental is generally treated as unrecaptured section 1250 gain first, up to the depreciation allowed or allowable. Only recognized gain above that gets the 0%, 15%, or 20% long-term rates.
Here, $80,000 of the $100,000 is unrecaptured section 1250 gain and $20,000 is long-term capital gain. At the top rates, that's $80,000 x 25% = $20,000, plus $20,000 x 20% = $4,000. If the 3.8% net investment income tax applies to you, it can add up to $100,000 x 3.8% = $3,800. So taking $100,000 out could cost up to $27,800 in federal tax, before any state tax.
That assumes no other gains or losses from business property this year and no net losses of that kind in the past five years. Either can change the result, and prior losses can turn part of the gain into ordinary income. Your CPA checks this.
With cost segregation, components such as appliances and carpet are Section 1245 property. Personal property like appliances isn't like-kind to real estate, and Section 1245(b)(4) doesn't cap ordinary-income recapture at the boot, so some can show up even with little or no cash out. Land improvements are generally Section 1250 property, where bonus depreciation above straight-line is recaptured as ordinary income within the Section 1250(d)(4) limits. See depreciation recapture for those classes.
How debt on the replacement changes the result
Under Treasury Regulation 1.1031(d)-2, debt you take on with the replacement property offsets the debt paid off at your sale, and so does cash you add from outside the exchange. New debt doesn't offset cash you receive.
Two variations:
- A smaller loan. You buy a $450,000 property with the $300,000 from the QI and a $150,000 loan. The old $200,000 mortgage is only partly replaced, so $50,000 of net debt relief is mortgage boot on top of the $100,000 cash. Recognized gain becomes $150,000.
- A bigger loan. You buy a $550,000 property with the $300,000 and a $250,000 loan. The extra $50,000 of debt doesn't cancel any of the $100,000 cash. Recognized gain stays $100,000.
To take exactly $100,000 out, the replacement loan has to be at least as large as the old payoff, or you add outside cash to cover the gap. If you'll use a DSCR loan, confirm the lender will lend at least your payoff amount before you set the cash number.
To run that math on your sale, talk to a 1031 consultant.
Plan the cash with your QI before the sale closes
Once proceeds reach your QI, Treasury Regulation 1.1031(k)-1(g)(6) requires the exchange agreement to bar you from receiving, pledging, or borrowing against the money before the exchange period ends. The exceptions are narrow. Money can come back after you've received all the replacement property you're entitled to under the agreement, or after day 45 if you identified nothing. It can also come back after day 45 if a material and substantial contingency occurs that relates to the exchange, is written into the agreement, and is outside the control of you, your family, and your advisers. Changing your mind on day 30 doesn't get you cash on day 31.
That leaves two practical windows:
- At the sale closing. Set the cash amount before closing and tell your QI and the closing agent, so the rest goes straight to the QI. Under Regulation 1.1031(k)-1(f), that money is taxable boot. Receiving part of the proceeds doesn't by itself turn the exchange into a sale. Receiving all of it does.
- When the agreement releases it. Money left with the QI after you've bought everything you're entitled to, or at the end of the exchange period (day 180 or your return's due date with extensions, if earlier), comes back to you as boot.
If leftover cash comes back the year after your sale, the regulation's installment rules may let you report that gain in the year you receive it, but only if it was reasonable, when the exchange began, to believe you'd complete it, and only for property held for business or investment. Ordinary-income recapture, such as on cost-segregated components, stays in the sale year under Section 453(i). That rule doesn't reach the 25% unrecaptured section 1250 gain. See the qualified intermediary's role for what to ask before you sign.
When taking cash makes sense
Taking cash makes sense when you have a specific use for it and accept the tax. Some sellers want reserves for the new loan. Lineage recommends keeping six months of the full payment, including taxes and insurance, in a cash or investment account, and your consultant confirms the lender's minimum. Others don't want to buy more property than their plan calls for.
The cost is tax at up to 25% on the first dollars of gain and less property working for you. Run it both ways with your CPA before you set the amount, because once the proceeds sit with the QI, the regulation decides when you can change your mind.
Lineage does not give tax or legal advice. This article explains the federal rules in general terms. Your CPA and qualified intermediary confirm how they apply to your exchange.
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Frequently asked questions
Not all of it. On a depreciated rental, recognized gain is generally unrecaptured section 1250 gain first, taxed at a maximum 25%, up to the depreciation allowed or allowable.
Generally no. The exchange agreement has to bar access until the exchange period ends, except in the narrow cases the regulation allows.
No. New debt offsets old debt, but it never offsets cash you receive.