Downsizing with a 1031 Exchange: What Investors Need to Know
Selling a larger investment property to buy a smaller one might sound like a simple transaction — but if you want to defer capital gains taxes through a 1031 Exchange, there are some important details to understand.
Yes, it’s possible to complete a 1031 Exchange while downsizing. However, because the new property’s value is lower, the IRS considers part of the transaction taxable. Let’s break down how this works, what the “catch” really is, and how to minimize your tax exposure when exchanging into a smaller property.
What Happens When You Downsize in a 1031 Exchange
A 1031 Exchange allows real estate investors to defer capital gains taxes by reinvesting the proceeds from a sold investment or business property into another “like-kind” property.
To fully defer taxes, the IRS requires two key conditions:
The replacement property (or properties) must be of equal or greater value than the one sold.
All net proceeds from the sale must be reinvested.
When you downsize — meaning your replacement property costs less than your relinquished property — one or both of these conditions aren’t fully met. The difference between what you sell and what you reinvest is known as “boot.”
Understanding the “Boot” and Its Tax Implications
Boot refers to any cash or non-like-kind property received by the investor in a 1031 Exchange. It’s the “catch” in a downsizing exchange because it becomes taxable to the extent of your realized gain.
Example:
You sell an apartment building for $1,200,000 and buy a smaller property for $1,000,000. The $200,000 difference — assuming it’s received in cash or used to pay down debt — is boot. You’ll owe capital gains tax on that portion, while the rest of your investment ($1,000,000) remains tax-deferred under Section 1031.
Can You Still Benefit from a Partial Exchange?
Absolutely. A partial 1031 Exchange — where you reinvest most, but not all, of the proceeds — can still deliver significant tax advantages.
Even though you’ll pay tax on the portion taken out as boot, you can defer taxes on the remainder. For many investors, especially those nearing retirement or seeking to rebalance their portfolios, this approach strikes the right balance between liquidity and tax efficiency.
Common Reasons Investors Downsize
Investors might choose to exchange into a smaller property for several reasons, including:
Simplifying management — trading an active, high-maintenance property for a more passive investment (e.g., triple net lease).
Diversifying portfolio risk — freeing up some cash to reinvest elsewhere.
Approaching retirement — reducing property responsibilities while still maintaining tax deferral on a portion of gains.
Improving cash flow — selecting a smaller property with a stronger income yield.
While downsizing can align with these goals, it’s important to plan the exchange carefully to avoid unexpected tax consequences.
IRS Compliance Rules Still Apply
Even when downsizing, all IRS 1031 rules remain in effect:
Use a Qualified Intermediary (QI): You can’t take direct control of sale proceeds at any time during the exchange.
45-Day Identification Period: You must identify your replacement property (or properties) within 45 days of selling the relinquished property.
180-Day Exchange Period: The purchase of the replacement property must be completed within 180 days of the sale.
Like-Kind Requirement: Both properties must be held for business or investment use — personal residences do not qualify.
A Qualified Intermediary ensures funds are transferred correctly and the transaction complies with IRS timing and reporting requirements.
Strategies to Minimize Tax When Downsizing
If you plan to downsize, consider these approaches to reduce or manage your taxable boot:
Reinvest as much as possible — even if you can’t match the full sale value, minimizing the difference reduces taxable gain.
Offset boot with exchange expenses, such as intermediary fees or closing costs, when allowed.
Consult your tax advisor — to explore options like pairing your exchange with other tax strategies or timing future sales strategically.
The Bottom Line
Yes, you can do a 1031 Exchange when downsizing — but any reduction in property value or equity rolled over will trigger partial taxation. Still, a partial exchange is better than a taxable sale, since you’ll continue deferring taxes on the portion reinvested.
By working with a Qualified Intermediary and planning the transaction carefully, investors can successfully transition into smaller or simpler assets without losing the core benefits of Section 1031.
Disclaimer: This article is for informational purposes only and should not be considered tax or legal advice. Investors should consult a Qualified Intermediary, CPA, or tax professional familiar with IRS Section 1031 regulations before proceeding with any exchange.
