How to Partially Cash Out in a 1031 Exchange—Without Getting Burned at Tax Time

Most savvy real estate investors know the basic rule of a 1031 Exchange: reinvest all your equity and maintain or increase your debt load to defer capital gains taxes. But what if you want to keep some cash on the sidelines?

Whether it’s for paying off other debts, funding a child’s college education, or simply enjoying the fruits of your investment success, the idea of taking “boot” (i.e., cash or non-like-kind property) from a 1031 Exchange is tempting. The good news? It’s possible. The caveat? You’ll want to be smart about how you do it.

The Basics: Equal or Up Is the Golden Rule

To fully defer taxes under IRC §1031, you must:

  • Reinvest all net equity

  • Acquire replacement property of equal or greater value

  • Follow strict timelines: identify property in 45 days and close within 180 days

Debt can be replaced with new cash, but not the other way around. You cannot offset cash received at closing by taking on more debt in the replacement property.

Common Reasons Investors Choose to “Exchange Down”

Investors sometimes choose to retain a portion of their sale proceeds. Reasons include:

  • Paying off personal or business debt

  • Diversifying into non-real estate investments

  • Limited supply of suitable replacement properties

  • Acquiring property debt-free after selling leveraged real estate

However, doing so usually triggers a taxable event on the portion not reinvested.

What Is Boot—and Why It Matters

The portion of sale proceeds not reinvested is called “boot.” Boot is taxable and may be subject to:

  • Capital gains tax (up to 20%)

  • Depreciation recapture (25%)

  • Net investment income tax (NIIT)

  • State income taxes

Example: An investor sells a property for $1 million, reinvests only $800,000, and retains $200,000. Assuming typical federal and state tax rates, their tax bill could exceed $80,000.

Smarter Strategy: Refinance After the Exchange

If your goal is to access liquidity without taking a tax hit, here’s a savvy workaround: reinvest the full amount in the replacement property, then refinance it after closing to extract cash.

As long as the refinance is not part of a pre-arranged plan tied to the purchase, the IRS typically does not treat it as taxable. This allows you to access funds while still enjoying full tax deferral under Section 1031. But note: partnerships may face different rules for “debt-financed distributions,” so consult a tax advisor first.

Bottom Line: Know Before You Close

Partial 1031 Exchanges are not inherently problematic—but they do come with consequences. If you plan to retain any proceeds, you must understand the tax implications and have a strategy in place. Consider looping in a CPA or tax attorney early in the process.

Want to explore the refinance-after-exchange approach or other advanced 1031 strategies? Let’s talk.

FAQ’s

1. “How long should I wait after closing on the replacement property before refinancing to avoid IRS scrutiny?”

There is no officially mandated waiting period from the IRS, but most tax advisors recommend waiting at least 6–12 months to establish clear separation between the exchange and the refinance. The key is to avoid the appearance of a prearranged plan. Always consult your CPA or legal advisor to tailor this timing to your situation.

2. “If I only partially reinvest due to a failed property identification, can I still defer some of the taxes?”

Yes. You can defer taxes proportionate to the amount reinvested. The portion not reinvested—called “boot”—will be subject to capital gains, depreciation recapture, and possibly state and NIIT taxes. While it’s not a full deferral, you still receive tax deferral benefits on the amount that qualifies under 1031 rules.

3. “Are there any specific rules or limitations if I’m doing a 1031 Exchange as part of an LLC or partnership?”

Yes. Exchanges involving partnerships can be complex, particularly if one or more partners want to cash out while others want to exchange. Additionally, any “debt-financed distributions” to partners after the exchange can trigger taxable events. Structuring the deal correctly—sometimes using a “drop and swap” strategy—requires close coordination with legal and tax professionals.