Do I have to replace my mortgage in a 1031, or can I add cash instead?

You never have to borrow again, but the loan you walk away from has to be covered by something

Nothing in section 1031 requires replacement financing. The requirement is that the debt relieved stops looking like money you received, and there are exactly two ways to achieve that: take on liabilities of at least the same size, or pay cash of the same size into the purchase.

Legal 1031 lists all three permutations - equal or greater financing on the replacement, replacing the debt with "outside money," or "a mix of debt and cash equal to the value of the debt satisfied." Realized 1031 states the same principle as "cash can be used to offset any difference if the replacement debt is lower."

Nor does the new debt have to resemble the old. A $600,000 fifteen-year commercial mortgage can be replaced by $600,000 of thirty-year agency debt, by an assumed seller loan, or by nothing at all if $600,000 of your own money goes in instead.

Reg. §1.1031(d)-2 counts the cash you pay against the debt you shed

Example 2 of Treas. Reg. §1.1031(d)-2 contains the sentence deleveraging sellers rely on: "consideration given in the form of cash or other property is offset against consideration received in the form of an assumption of liabilities or a transfer of property subject to a liability."

The example's arithmetic is short. E gives up a property carrying a $150,000 mortgage, takes property subject to an $80,000 mortgage, and pays $40,000 in cash; the $150,000 of relief is reduced to $30,000 of boot by the $80,000 assumed plus the $40,000 paid.

Form 8824 runs the identical calculation for you. Line 15 is the excess of liabilities assumed by the other party over "(a) any liabilities you assumed, (b) cash you paid to the other party, and (c) the FMV of the other (non-like-kind) property you gave up" (Instructions for Form 8824).

The all-cash trap: a $6,000,000 sale with a $2,500,000 loan

Hypothetical, round numbers and no closing costs, to keep the point visible. You sell for $6,000,000, the $2,500,000 loan is paid off at closing, and $3,500,000 of equity reaches the intermediary. You then buy a $3,500,000 building free and clear.

Every dollar of equity went to work, and the result is still $2,500,000 of mortgage boot, because nothing replaced the loan. The exchange did not fail - it simply deferred far less than you expected.

To own real estate free and clear with no boot at all, you have to buy $6,000,000 and add $2,500,000 of your own money to the $3,500,000 from the account. The middle path is the common one: buy the full $6,000,000 with a $1,000,000 loan and $1,500,000 of outside cash, and the debt leg still clears.

• Buy $6,000,000 with a $2,500,000 loan: debt fully replaced, no outside money needed, leverage unchanged.
• Buy $6,000,000 with a $1,200,000 loan plus $1,300,000 of outside cash: leverage halved, still no boot.
• Buy $6,000,000 all cash by adding $2,500,000: no debt at all, no boot, and the largest cash requirement.
• Buy $3,500,000 all cash with proceeds only: nothing added, and $2,500,000 recognized - the version most sellers stumble into.

Paying the loan down before you list changes the mix, not the target

Suppose you put $500,000 of savings against that $2,500,000 mortgage two months before closing. At closing only $2,000,000 of debt is relieved and $4,000,000 reaches the intermediary, so the debt leg shrinks and the equity leg grows by the same amount.

The total you have to replace is unchanged at $6,000,000. You have converted debt into equity, which lowers the replacement financing you need but does not reduce the purchase price you must reach.

The risky version is the opposite move - drawing new debt against the property shortly before the sale so that cash comes out ahead of the exchange. The refinance timing guide sets out why the timing of that borrowing matters, and can I pay down the mortgage on a property I already own covers the related question about other properties.

Where replacement debt comes from when you do want leverage

A conventional loan on the replacement is the obvious source, and the intermediary's funds can serve as the down payment on it; can I get a mortgage on the replacement using exchange funds covers the sequencing with the lender.

Seller financing on the purchase counts too, because a note you give the seller is a liability you assumed rather than cash you received. Note that a note you take back on the property you are selling works in the other direction and is boot to you - see carrying a note for my buyer.

A Delaware Statutory Trust carries its own non-recourse financing, and an investor's pro-rata share of that loan is treated as debt for these purposes; can a DST's loan count as replacement debt sets out how the share is measured and what leverage levels are typical.

Recourse, nonrecourse and assumed loans are all netted the same way

The form of the liability does not change the arithmetic. PLR 201648013 restates the rule from Reg. §1.1031(j)-1(b)(2) that liabilities assumed are offset against liabilities relieved "regardless of whether the liabilities are recourse or nonrecourse and regardless of whether the liabilities are secured by or otherwise relate to specific property transferred or received."

So a personally guaranteed bank loan can be replaced by non-recourse trust debt, and a single relinquished loan can be replaced by debt spread across two replacement properties. What matters is the total on each side of the exchange.

Have your CPA or attorney confirm the two totals from the draft settlement statements before closing, because this is one of the few exchange figures that can still be adjusted while the purchase is being structured.