Understanding Partial 1031 Exchanges and Cash-Out Options

A 1031 Exchange is a powerful tool that allows real estate investors to defer capital gains taxes by reinvesting proceeds from the sale of an investment property into another like-kind property. However, not every exchange needs to be all or nothing. Investors can choose to take a portion of their sale proceeds in cash or other non-like-kind property while still completing a valid exchange. This is known as a Partial 1031 Exchange.

Let’s explore how partial exchanges work, what’s considered taxable, and how the IRS views “cash-out” strategies.

What Is a Partial 1031 Exchange?

In a full 1031 Exchange, all sale proceeds from the relinquished property are reinvested into one or more like-kind replacement properties, and all proceeds are held by a Qualified Intermediary (QI) to ensure compliance with IRS rules.

A partial 1031 exchange occurs when an investor reinvests only part of the proceeds into a new property and chooses to receive the rest in cash or non-like-kind property. The portion not reinvested is known as “boot.”

Understanding “Boot” and Taxable Gains

The IRS uses the term boot to describe anything of value received by the investor that is not like-kind property. This can include:

• Cash received at closing

• Debt relief not replaced on the new property

• Personal property included in the transaction

Any boot received becomes taxable to the extent of the capital gain. In other words, while the reinvested portion remains tax-deferred, the boot portion will be recognized as taxable gain in the year of the exchange.

Example:

If you sell an investment property for $1,000,000 and reinvest $800,000 into a new property while receiving $200,000 in cash, the $200,000 is taxable boot. The remaining $800,000 continues to enjoy tax deferral under Section 1031.

Cash-Out Strategies and Timing Considerations

Investors sometimes plan partial exchanges to access cash for other purposes—such as paying down debt, funding another investment, or improving liquidity. While this can be legitimate, the IRS pays close attention to the timing of when cash is received.

• At closing: Any funds taken directly at the time of sale are treated as taxable boot.

• After the exchange: If funds are distributed after the replacement property has been acquired, the exchange is still considered valid, but the cash received will still be taxable.

• Before the exchange is complete: Receiving or controlling exchange funds before the transaction concludes can invalidate the entire 1031 Exchange.

That’s why using a Qualified Intermediary (QI) is essential — the QI holds and disburses the funds properly to maintain compliance.

Debt Replacement Rules

Another common way investors accidentally create taxable boot is by not replacing the debt from their relinquished property.

For example, if your sold property had a $500,000 mortgage, and your replacement property only carries $400,000 in debt (with no additional cash contribution), the $100,000 shortfall is considered boot and is taxable. To avoid this, you must replace