In a §1031 exchange with mortgaged property, the relinquished loan is paid off from sale proceeds at closing — the QI never touches the loan payoff. The taxpayer then arranges new financing on the replacement property as an independent transaction with a new lender. The §1031 statute requires the taxpayer's debt level on the replacement to equal or exceed the debt on the relinquished, or mortgage boot is recognized to the extent of the reduction. Adding fresh cash offsets mortgage boot. Loan assumption is rare; new financing is the standard.
Most §1031 exchanges involve mortgaged property on at least one side. The mechanics of debt in a 1031 are often misunderstood: the loan does not transfer, the QI does not handle the new loan, and the taxpayer must satisfy a debt-replacement test or recognize mortgage boot. Getting this right preserves full deferral; getting it wrong produces a partially taxable exchange.
How the Old Mortgage Is Paid Off (Title Transfer)
At the relinquished property closing, the title company collects the buyer's purchase funds, pays off the relinquished mortgage from those proceeds, and wires the net proceeds (sale price minus loan payoff minus closing costs) to the QI's exchange escrow account. The QI never touches the loan payoff — that flows directly from the title company to the existing lender as a standard sale transaction.
The taxpayer's existing lender treats this as a normal payoff at sale, not as anything special for §1031. The lender issues a payoff statement, the title company wires the payoff at closing, and the lender releases the lien. From the lender's perspective, the §1031 is invisible.
The QI's role is limited to receiving the net proceeds — the cash that remains after loan payoff and closing costs. Those net proceeds become the §1031 exchange funds and must satisfy the equal-or-greater-equity rule on the replacement.
New Financing on the Replacement (Independent Transaction)
The new mortgage on the replacement property is an entirely independent transaction. The taxpayer arranges financing with a new lender (or the same lender, if they offer it on the replacement), goes through underwriting, signs new loan documents, and closes the new loan in conjunction with the replacement closing. The QI does not arrange, sign, or guarantee the new loan.
Mechanics at replacement closing:
- The QI wires exchange funds (net proceeds from the relinquished sale) to the title company.
- The new lender wires loan proceeds to the title company.
- The taxpayer wires any fresh cash needed to close the gap.
- The title company combines all three sources, pays the seller, records the deed in the taxpayer's name, and records the new mortgage.
The combination of QI funds + new loan + (optional) fresh cash must equal the replacement purchase price plus closing costs. Any shortfall fails the closing; any surplus is returned to the taxpayer (and may create boot).
The Debt-Replacement Rule (Equal or Greater)
The §1031 regulations and decades of case law establish that the taxpayer's debt level on the replacement must equal or exceed the debt on the relinquished, or the difference is treated as taxable mortgage boot. This is one half of the broader "equal-or-greater-value" requirement; the other half is total value.
Worked example:
- Sell rental: $700K, $400K mortgage paid off, $300K to QI.
- Buy rental: $700K purchase price, $200K new mortgage.
- Equity needed at closing: $700K - $200K = $500K.
- QI provides $300K. Shortfall: $200K.
- Debt comparison: $400K relinquished - $200K replacement = $200K debt reduction.
- Mortgage boot exposure: $200K (the debt reduction equals the equity shortfall).
The taxpayer can choose: (a) close as-is and recognize $200K mortgage boot (taxable), or (b) add $200K fresh cash to fill the equity gap and offset the mortgage boot (zero tax recognition).
Mortgaged exchange?
Simple 1031 LLC documents debt-replacement math and equity calculations on every file. $799 flat fee for forward exchanges. Same-day exchange opening on the first call.
Call (725) 224-5008Mortgage Boot When Debt Drops
Mortgage boot is the most common boot type in §1031 exchanges and is widely misunderstood. It arises whenever debt on the replacement is less than debt on the relinquished — the "debt relief" is treated as cash received by the taxpayer for tax purposes, even though no actual cash changed hands.
The IRS view: by paying off $400K of relinquished debt and taking on only $200K of replacement debt, the taxpayer has been "relieved" of $200K of obligation. That relief is economically equivalent to receiving $200K cash. Therefore it is taxable boot to the extent of realized gain.
Mortgage boot is taxable as the underlying gain — long-term capital gain on appreciation, ordinary recapture on depreciation. Combined federal+state rates of 25-30% on a $200K mortgage boot means $50K-$60K of immediate tax.
Offsetting Mortgage Boot With Added Cash
Mortgage boot can be offset by adding fresh cash to the exchange. The IRS asymmetry: cash extracted from the exchange is boot (taxable), but cash added to the exchange is not boot and offsets mortgage boot dollar-for-dollar.
Worked example continuing:
- Mortgage boot exposure: $200K.
- Taxpayer adds $200K fresh cash to the QI's $300K = $500K total equity at closing.
- Net mortgage boot: $0. Full deferral achieved.
The fresh cash can come from any source — savings, HELOC on a different property, family loan, business distribution. The §1031 statute does not restrict where it comes from, only that it is added before closing.
Assumption vs. New Financing (Rare vs. Common)
Loan assumption — where the buyer takes over the existing mortgage rather than paying it off — is rare in modern residential and commercial real estate. Most loans are not assumable, and even assumable loans require lender approval. In a §1031 context, assumption mechanics differ from a standard payoff:
- Buyer assumes relinquished loan. The buyer of the relinquished property takes over the mortgage. The taxpayer is released from the loan (subject to lender approval). The QI receives only the equity portion of the sale, not the gross sale price.
- Taxpayer assumes replacement loan. The seller of the replacement property has an existing assumable loan that the taxpayer takes over. The QI funds the equity portion; the taxpayer takes on the existing debt.
For §1031 debt-replacement purposes, an assumed loan counts the same as a new loan — the IRS looks at the taxpayer's total debt obligation, not the source. Most modern exchanges use new financing on the replacement because assumable loans are uncommon and assumption approval timelines often conflict with the 180-day closing window.
Simple 1031 LLC documents the debt-replacement math on every exchange and coordinates with the title company on closing wires. We are a Qualified Intermediary and do not provide tax, legal, or investment advice — the strategic decision on whether to add cash, the financing structure, and the gain/recapture math should be modeled with your CPA and lender before closing.
Frequently Asked Questions
Can I assume the seller's mortgage on my replacement?
Only if the seller's loan is assumable, which is uncommon in modern residential and commercial markets. Assumable loans typically include older FHA, VA, and USDA loans on residential property; conventional commercial and most modern residential loans contain due-on-sale clauses that prevent assumption without lender consent. If assumption is available, the §1031 treats the assumed debt the same as new debt for the equal-or-greater-debt rule. Assumption approval timelines must fit within the 180-day window, which often makes new financing more practical.
What if my new loan is smaller than the old one?
The difference is mortgage boot — taxable to the extent of realized gain at the underlying gain rate (long-term capital gain or ordinary recapture). Mortgage boot can be offset dollar-for-dollar by adding fresh cash to the exchange, increasing the taxpayer's equity in the replacement to a level that compensates for the reduced debt. A taxpayer dropping from $400K relinquished debt to $200K replacement debt has $200K of mortgage boot exposure, fully offsettable by adding $200K cash.
Can I pay loan payoff with exchange funds?
The relinquished loan is paid off from the buyer's purchase funds at closing, not from QI exchange funds. The exchange escrow only receives net proceeds (sale price minus loan payoff minus closing costs). On the replacement side, exchange funds can be used to satisfy any balance not financed by the new loan — that's the equity portion of the closing wire. The QI does not pay the new lender or service any debt; the QI only delivers exchange funds to the title company at replacement closing.
Does a cash-out refi after closing create boot?
A cash-out refinance on the replacement property after the exchange has closed is generally not boot if the refinance is independent and timed appropriately. The IRS scrutinizes refinances done in close proximity to the §1031 closing under a 'step transaction' analysis — refinancing within days of closing on the replacement may be recharacterized as effective cash boot. Most practitioners recommend waiting 6+ months after the §1031 closes before doing a cash-out refi, though the rules are case-specific. Discuss timing with your CPA before any refi.
How does seller financing work in a 1031?
Seller financing on the relinquished property — where the taxpayer carries back a note from the buyer — creates §1031 complications because the note proceeds arrive in installments rather than as a lump sum at closing. The QI cannot hold a promissory note as exchange funds; the IRS treats note repayments as either installment-sale income (under §453) or as boot under §1031. The most common structures are: (a) sell the note to a third party for cash before the QI receives funds, (b) treat the note as boot and accept the partial taxable result, or (c) use a hybrid §1031/§453 structure. Each requires CPA review.
Mortgaged exchange?
Simple 1031 LLC documents debt-replacement math and coordinates with title and lender on every file. $799 flat fee for forward exchanges, $5M Fidelity Bond and $10M E&O coverage, segregated escrow on every file.