Partial 1031 Exchange: The Real Cost of Cash Out

Not every 1031 exchange needs to defer 100% of the gain. Some investors intentionally take a portion of their proceeds out in cash, an approach known as a partial exchange. But that cash, referred to as boot, is taxable, and the tax bill it creates is often larger than investors expect.

This guide explains what boot is, how it’s taxed, and a cheaper alternative many investors overlook.

What Counts as Boot

Boot is any value you receive in an exchange that isn’t like-kind replacement real estate. The most common form is cash boot, simply keeping some of the sale proceeds instead of reinvesting all of them.

Mortgage boot is a second, less obvious form: if the debt on your replacement property is lower than the debt you paid off on the relinquished property, the difference is treated as boot even if you didn’t receive actual cash.

How Boot Is Actually Taxed

Boot is taxed dollar for dollar as gain, up to the total gain realized on the sale. It doesn’t get the benefit of deferral, and depending on how much of your gain is attributable to depreciation recapture versus capital appreciation, the blended tax rate on that boot can run higher than investors expect, since depreciation recapture is generally taxed at a higher federal rate than long-term capital gains.

State taxes apply on top of this, and because boot is recognized in the year of the exchange, it can also affect your overall tax bracket for that year.

A Cheaper Way to Access Liquidity

Investors who want cash without triggering boot often refinance the replacement property after the exchange closes, rather than pulling cash out during the exchange itself. Because a cash-out refinance is a loan, not a sale, the proceeds are generally not taxable, and refinancing after closing avoids intermingling loan proceeds with exchange funds in a way that could jeopardize the exchange.

Timing matters here: refinancing too close to the exchange closing, or using pre-arranged refinancing tied to the exchange itself, can draw IRS scrutiny under the step-transaction doctrine, so most practitioners recommend waiting a reasonable period after closing before refinancing.

When Taking Boot Still Makes Sense

Sometimes taking a calculated amount of boot is still the right call, for example when the tax cost is modest relative to a pressing need for liquidity, or when reinvesting 100% of proceeds would force you into a replacement property that doesn’t fit your investment goals. The key is knowing the exact tax cost in advance rather than being surprised by it after the fact.

Frequently Asked Questions

Is boot taxed at capital gains rates or ordinary income rates?

It depends on the composition of your gain. The portion of boot attributable to depreciation recapture is generally taxed at a maximum federal rate of 25%, while the remainder is typically taxed at long-term capital gains rates, assuming the property was held long enough to qualify.

Can my Qualified Intermediary calculate my exact boot tax liability?

A QI administers the exchange mechanics but doesn’t typically provide tax advice or calculate your liability. That calculation should come from your CPA or tax advisor, ideally before you decide how much cash to take out.

Does refinancing before the exchange closes create the same problem as taking boot?

Refinancing the relinquished property shortly before an exchange can also create boot exposure if it’s viewed as a way to extract cash in connection with the exchange. Most advisors recommend refinancing well before a sale is contemplated, or well after a replacement property exchange has closed.

The Bottom Line

Cash out of a 1031 exchange is rarely free. Boot is taxed immediately and often at a higher effective rate than investors anticipate once depreciation recapture is factored in. For investors who need liquidity, refinancing the replacement property after closing is frequently the lower-cost path, but the right answer depends on your specific numbers and timeline.

Talk to a Specialist about modeling the tax cost of a partial exchange against your liquidity needs before you decide how much, if any, cash to take out.

This article is educational and is not tax, legal, or investment advice. Consult your own CPA, tax attorney, and qualified financial professional before pursuing a 1031 exchange.