What is the 1031 debt replacement rule?

Hans Goldstein structures installment sales for sellers and works alongside their CPAs and brokers. Email hans@goldsteinco.net or call 213-414-2808.

Go deeper: how mortgage boot and cash boot are taxed in a 1031 exchange on Big Sale Tax.

Where does the rule come from?

It comes from two places. IRC §1031(b) says that when you receive money or other property along with like-kind property, you recognize gain up to the amount of that money and other property. Treas. Reg. §1.1031(d)-2-2) adds that when someone else takes over or pays off a liability of yours in the exchange, that relief counts as money received. Its Example 2 lays out the netting: liabilities you take on with the replacement offset liabilities you are relieved of, cash you pay offsets them too, and what is left is boot.

There is no separate "debt rule" in the statute. It is the boot rule applied to the loan. Paying off your mortgage at closing puts money in your hands in substance, even though it went straight to your lender.

How does the netting actually work?

Four steps, done once for the whole exchange:

1. Debt relieved. Every loan or lien paid off or taken over on the property you sold.
2. Minus debt taken on. Every loan on the replacement, new or assumed.
3. Minus cash you add from outside the exchange. The result, if positive, is net mortgage boot.
4. Plus cash or other property you receive. This is added on its own. Extra debt on the replacement side cannot reduce it.

Recognized gain is the lesser of your realized gain or that total. Deferred gain is the rest, and it carries into the replacement through a lower basis.

Two asymmetries matter in practice:

• Cash in offsets debt out. If you pay down less debt than you took on, or write a check at closing, that cash reduces mortgage boot dollar for dollar.
• Debt in does not offset cash out. Taking on a bigger loan does not cancel cash you take out. If you pocket $500,000 at closing, a loan $500,000 larger than the old one does not fix it.

How does it work on a real deal?

Here is a deal on my desk, rounded. An office building selling for about $4.0M at about a 6.4% cap rate, with a $2.1M loan taken out seven months before the sale. The owner bought it for $885,000 in 2019.

Illustrative assumptions for the tax lines: $130,000 of depreciation taken since 2019 (the real figure is not known yet), so an adjusted basis of $755,000 ($885,000 minus $130,000). Closing costs and any prepayment penalty are ignored to keep the arithmetic clean. Realized gain is $4,000,000 minus $755,000 = $3,245,000. The equity that reaches the qualified intermediary is $4,000,000 minus $2,100,000 = $1,900,000.

Check on the deferred gain: replacement price minus deferred gain should equal the carried-over basis. A: $4,000,000 minus $3,245,000 = $755,000. B: $3,400,000 minus $2,645,000 = $755,000. C: $4,000,000 minus $3,245,000 = $755,000. All three land on the old basis, which is how it should work.

Scenario C shows why cash fixes a debt shortfall: the $600,000 check buys the same $4.0M building with $600,000 less debt and no boot. Scenario B is the same equity and the same loan, just no check, so the $600,000 of unreplaced debt becomes taxable.

What would the tax on that $600,000 look like?

Illustrative only, scenario B, federal only, assuming the seller's other income already puts them in the top brackets, no cost segregation (so no ordinary recapture on the building), and that the recognized gain is treated as the depreciation piece first:

State tax comes on top in most states. The ordering, the rates that actually apply and whether the 3.8% applies (it may not for a qualifying real estate professional) are your CPA's call. See unrecaptured §1250 gain for how the depreciation piece is taxed.

Why doesn't a bigger loan cancel cash I take out?

Because the regulation nets liabilities against liabilities and lets cash you pay offset liabilities, but it does not let liabilities you take on offset cash or other property you receive.

Illustrative scenario D on the same deal: the seller takes $500,000 of the equity in cash at closing and puts the other $1,400,000 into a $4.0M replacement with a $2,600,000 loan. Debt taken on ($2,600,000) is more than debt relieved ($2,100,000), so net mortgage boot is zero. The extra $500,000 of debt does nothing for the $500,000 of cash. Recognized gain: $500,000. If you need cash out of a sale, take it as a separate decision and price the tax, rather than assuming a larger loan covers it.

The market as of October 2026

Replacing debt now means borrowing at this fall's prices. As of Oct. 1, 2026, Northmarq's rates and spreads showed 10-year quotes of 6.30% to 6.45% for Freddie Mac, 6.65% to 6.95% for life companies and 7.00% to 7.50% for CMBS. The 10-year Treasury was 5.24% on Oct. 1, 2026 (FRED, DGS10). Credit is available: in the July 2026 survey (released Aug. 3, 2026), moderate and modest net shares of banks reported easing standards for nonfarm nonresidential and multifamily loans (Fed SLOOS, July 2026). The tax rule counts only the size of the debt, though. The price of that debt shows up in cash flow, and on this deal it is worth comparing with the 6.4% the building earns (negative leverage in a 1031, and the 2026 rate picture).

What are the ways to close a debt gap?

• Borrow the full amount (scenario A). Full deferral, and a new loan at today's rates.
• Add cash (scenario C). Full deferral, and less leverage, if you have the outside money.
• Accept the boot (scenario B). Smaller replacement, smaller loan, tax on the shortfall now.
• Take on the replacement's existing debt by assumption, or through a Delaware statutory trust interest, where your share of the trust's loan counts (assuming a loan in a 1031).

A seller who decides against new debt entirely has another route: a structured installment sale, where the buyer pays in full at closing and part of the price goes to an assignment company that funds a fixed annuity from an insurer, with gain reported under IRC §453 as payments arrive. The flip side, stated once: the old $2.1M loan is still paid off at closing, prepayment penalty included, and that payoff is a year-one payment taxed at the sale's gross profit ratio. There is no debt replacement test because there is no exchange; what it removes is the new loan, the new rate and the landlord job. The trade-offs: payments are locked once set and cannot be accelerated or cashed out, they depend on the assignment company and the insurer behind it, there is no published IRS ruling on this specific structure so your CPA should review it, a commission of about 4% of the amount structured is built into the pricing, and interest in each payment is ordinary income. It must be in the purchase agreement before closing.

Run both paths with your own numbers in the advanced calculator, or send Hans the deal and he will lay them side by side for your CPA.

Frequently asked

Q: What is mortgage boot in a 1031 exchange? A: It is debt you were relieved of on the property you sold that is not matched by debt on the replacement or by cash you added. The regulations treat it as money received, so it is taxable up to your realized gain.

Q: Can I add cash to avoid mortgage boot? A: Yes. Cash you pay in from outside the exchange offsets debt relief dollar for dollar. In the example above, a $600,000 check removes $600,000 of boot.

Q: Can I take cash out if I take on a bigger loan? A: Not without tax. Debt you take on does not offset cash you receive, so cash out of the exchange is boot regardless of the size of the new loan.

Q: Is mortgage boot taxed even if I never received any money? A: Yes. The loan payoff counts as money received for this purpose even though it went to your lender at closing. That is why a small replacement loan can create a tax bill with no cash to pay it.

What should you read or run next?

• 1031 boot calculator
• Do I need a new loan for a 1031 exchange?
• Negative leverage in a 1031 exchange
• 1031 exchange boot tax
• 1031 and installment sale together
• Advanced calculator

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