Yes, you can do a 1031 exchange for a lesser value property. The exchange still qualifies under Section 26 U.S.C. 1031, but you give up part of the tax deferral: the gap between what you sold and what you bought becomes “boot,” and boot is taxable in the year of the exchange.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment How much tax you owe depends on the size of the gap, your income bracket, and how much depreciation you claimed on the property you sold.
What Full Deferral Requires
To defer every dollar of gain, the replacement property has to clear two benchmarks. The purchase price must equal or exceed the net selling price of the property you gave up, and the debt on the new property must equal or exceed the debt on the old one. Miss either measure and the IRS treats the shortfall as recognized gain. The reasoning is that any value that leaked out of the exchange — cash in your pocket or debt you no longer owe — is a financial benefit, and benefits get taxed.
Section 1031 says no gain is recognized when investment real property is exchanged solely for like-kind real property.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment The word “solely” is the whole game. Once anything other than like-kind property enters the picture, that piece gets taxed.
Trading Down Creates a Partial Exchange
Buying cheaper doesn’t disqualify the exchange. The IRS splits the transaction: the portion of proceeds that flows into the new property stays deferred, and the leftover is recognized gain in the year of the exchange.2Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 The statute caps recognized gain at the amount of boot received, so you’ll never owe tax on more than the actual shortfall.1Office of the Law Revision Counsel. 26 U.S. Code 1031 – Exchange of Real Property Held for Productive Use or Investment
This is often called a partial 1031 exchange. It is legal, common, and sometimes the right call — an investor who wants to reduce management workload or pull equity out for other uses might accept the partial tax hit rather than force a match on the numbers. Trading down limits deferral; it does not void it.
Cash Boot and Mortgage Boot
Boot comes in two forms, and investors who watch only for one often get surprised by the other.
Cash boot is the obvious one. Sell for $500,000, buy for $450,000, and the $50,000 in unspent proceeds is cash boot. It doesn’t matter whether the money reaches your bank account or stays with the qualified intermediary. Any sale proceeds not reinvested count as taxable boot.3Internal Revenue Service. Sales Trades Exchanges
Mortgage boot is the one people miss. If the loan on the replacement is smaller than the loan you had on the property you sold, the IRS treats that debt reduction as a benefit received. Owe $300,000 on the old property, take on a $200,000 mortgage on the new one, and $100,000 in debt relief is boot even though no check ever crossed your desk.
Both types can appear in the same deal and they add together. Walk away with $30,000 in leftover cash and cut your mortgage by $70,000, and you have $100,000 in total boot exposed to tax.
Offsetting Mortgage Boot With Cash
Mortgage boot has a common workaround. If the replacement loan is smaller than the old one, you can bridge the gap by adding your own outside cash to the purchase. Sold with a $400,000 mortgage, replacing with a $300,000 loan? Contribute $100,000 of your own money toward the down payment and cash paid offsets mortgage boot received, dropping net boot to zero. This is the standard fix when replacement financing won’t match the old debt level.
How the Tax on Boot Adds Up
Boot is reported on IRS Form 8824, filed with the return for the year of the exchange.4Internal Revenue Service. Instructions for Form 8824 The form has you total the value received (cash, non-like-kind property, net debt relief) and compare it to your realized gain. Recognized gain is the lesser of the two.5Internal Revenue Service. Form 8824 Like-Kind Exchanges
That recognized gain gets hit by multiple taxes stacked on top of each other:
- Long-term capital gains tax at 0%, 15%, or 20% depending on filing status and taxable income. Most investors sit in the 15% bracket.6Internal Revenue Service. Topic No. 409, Capital Gains and Losses
- Depreciation recapture on the portion of gain tied to depreciation deductions claimed on the old property, taxed at a maximum 25% as unrecaptured Section 1250 gain. This catches investors who have forgotten how much depreciation they took over the years.6Internal Revenue Service. Topic No. 409, Capital Gains and Losses
- The 3.8% Net Investment Income Tax if modified adjusted gross income exceeds $200,000 for single filers or $250,000 for joint filers. These thresholds are not indexed for inflation.7Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
Stack all three and the effective federal rate on boot can easily reach 30% or more. On $100,000 of boot, that’s at least $30,000 in federal tax before any state tax. The portion of gain you don’t recognize carries into the basis of the new property and remains deferred until you sell it in a taxable transaction.
Ways to Close the Gap
If you’d rather not pay tax on the shortfall, three approaches can shrink or eliminate boot.
Add Cash to the Purchase
The simplest fix is writing a check. If the replacement is $80,000 cheaper, contributing $80,000 of your own non-exchange money to the deal eliminates the gap. This works for both cash and mortgage boot.
Buy More Than One Property
Nothing in Section 1031 requires a single replacement. You can buy two, three, or more smaller properties that together equal or exceed what you sold. An investor selling a $1.2 million apartment building might replace it with three $400,000 rental condos and defer the full gain. The IRS lets you identify up to three replacement properties of any value, or more than three so long as their combined value doesn’t exceed 200% of what you sold.
Use a Build-to-Suit Exchange
If the property you want is cheaper as-is, exchange funds can pay for improvements before you take title. The qualified intermediary holds the funds and pays for construction, and the finished property’s value counts toward the exchange.
Timing is unforgiving. Improvements must be physically completed and paid for before you take title. Escrowed money set aside for later work does not count. Only materials installed and services performed contribute to exchange value, and any unfinished construction at the end of the 180-day period leaves unused funds as taxable boot.
Deadlines and Rules That Still Apply
A partial exchange still has to clear every procedural hurdle of a full exchange. Miss one and the whole deferral collapses, not just the reinvested portion.
- You have 45 calendar days from the sale of the old property to identify replacement properties in writing, signed by you and delivered to the qualified intermediary or another permitted party.
- You have 180 calendar days from the sale to close on the replacement, or the due date of your return for that year including extensions, whichever comes first.
Neither deadline extends for weekends or holidays. Miss the 45-day window without identifying any property and the IRS treats the whole transaction as a straight sale, meaning capital gains, depreciation recapture, and potentially NIIT apply to the entire gain rather than just the shortfall.
You also cannot touch the sale proceeds at any point. Actual or constructive receipt turns the whole transaction into a taxable sale.3Internal Revenue Service. Sales Trades Exchanges Funds have to move through a qualified intermediary, and the IRS disqualifies anyone who has been your employee, attorney, accountant, investment banker, or real estate agent within the prior two years. Standard delayed-exchange fees typically run $600 to $1,200, with reverse and build-to-suit exchanges costing more.