Short answer: Your mortgage is paid off when you sell, and that payoff counts as money you received. To avoid mortgage boot, replace the debt with an equal or larger loan on the new property, or with added cash. You also need to buy at least your net sale price and reinvest all of your equity.
Reviewed by Jon Hilley. Last updated September 29, 2026.
A mortgage does not stop you from doing a 1031 exchange. The lender is paid off at the sale closing, the net equity goes to your qualified intermediary, and you finance the replacement property however you like. What matters is the debt math: under the rules for boot in a 1031 exchange, debt you are relieved of is treated like cash you received.
That means you cannot simply reinvest your equity and buy a smaller, debt-free property without tax. The replacement has to carry at least as much value as you sold, funded by your equity plus new debt or added cash.
Key rules
- Debt relief is boot: a mortgage paid off on the relinquished property counts as cash received (Treas. Reg. §1.1031(d)-2).
- New debt offsets old debt: debt you take on for the replacement offsets debt relieved, and cash you add offsets debt relief (Treas. Reg. §1.1031(d)-2).
- New debt does not cure cash boot: a bigger loan does not offset cash you take out of the exchange (Treas. Reg. §1.1031(d)-2).
- Recognized gain is capped: you are taxed on the smaller of realized gain or total boot (IRC §1031(b)).
- Loan costs can be boot: loan fees and other non-transaction costs paid from exchange funds can be taxable as boot (IRC §1031(b)).
How to avoid mortgage boot
To defer all of your gain, do three things: buy replacement property priced at or above your net sale price, reinvest all of your net equity, and replace the debt that was paid off with new debt or fresh cash. New debt can be a bank loan, seller financing on the replacement property, or a loan you assume. Nothing requires the new loan to match the old one dollar for dollar, as long as the total purchase price is covered by exchange equity plus new debt plus added cash.
Refinancing around an exchange
Pulling cash out through a refinance right before you sell can be challenged as taking boot in disguise. Financing placed on the replacement property after you acquire it is generally viewed more favorably. Timing matters, so plan any refinance with your CPA or tax attorney before you list the property.
Fannie Mae loans and 1031 exchanges
Conventional lenders, including those selling loans to Fannie Mae (FNMA), generally accept 1031 exchange funds as a source of the down payment when the exchange is documented. Fannie Mae's Selling Guide (B3-4.3-10) lists like-kind exchange funds as eligible for the down payment if they are properly documented and comply with Internal Revenue Code Section 1031. Expect your loan officer to ask for the exchange agreement and a statement from the QI showing the balance held. Conforming loans for one-to-four unit investment property are generally made to individual borrowers rather than LLCs. That works if you sold through a single-member LLC that is disregarded for tax, because you and the LLC are the same taxpayer. Fannie Mae's single-family loans cover one-to-four unit properties; larger apartment buildings and commercial property use multifamily or commercial loan programs with their own requirements. Confirm the lender's current requirements early, because a financing change late in the 180 days is hard to recover from.
In a reverse exchange, the lender has to lend to the exchange accommodation titleholder, which narrows the list of willing lenders. Some conforming loan programs do not allow reverse exchanges at all, so ask before you commit to that structure.
Example: mortgage boot on a smaller purchase
- Sale price: $1,200,000
- Selling expenses: $60,000
- Net sale price: $1,140,000
- Mortgage paid off: $500,000
- Net equity to the QI: $640,000
- Adjusted basis: $540,000 (after $200,000 of depreciation)
- Realized gain: $600,000
- Replacement price: $1,000,000 ($640,000 equity plus a $360,000 loan)
- Net debt relief (mortgage boot): $140,000 ($500,000 minus $360,000)
- Tax at 25% on $140,000: $35,000
- Net investment income tax at 3.8%: $5,320
- Total federal tax: $40,320
Assumptions: the full 25% rate applies because the boot is less than prior depreciation, the 3.8% net investment income tax applies, and state tax is not included. The investor reinvested every dollar of equity but still owes tax, because the replacement is $140,000 cheaper than the net sale price. Buying a $1,140,000 property with $640,000 of equity and a $500,000 loan would defer everything. So would $640,000 of equity, $140,000 of the investor's own cash and a $360,000 loan, since added cash offsets debt relief.
Model your own debt and cash with our partial boot calculator.
Other questions investors ask
Can you pay off an existing mortgage with a 1031 exchange?
Yes for the property you are selling: its mortgage is paid off at closing as part of the exchange. No for any other property: using exchange funds to pay down a loan on a property you already own is treated as receiving cash, which is taxable boot. See Can you 1031 exchange into a property you already own?
What are the requirements for a 1031 exchange mortgage?
There is no special loan product. The loan must be made to the same taxpayer who sold the relinquished property (or to a disregarded LLC you own), close within the 180-day window and meet the lender's normal underwriting. Expect the lender to ask for the exchange agreement and the QI's statement of funds held.
Common mistakes
- Matching equity but not value: the most common problem we see is an investor who reinvests all the cash, buys a cheaper property with a smaller loan, and is surprised by mortgage boot.
- Late loan approval: we see financing delays push closings past day 180. Start the loan application as soon as you identify.
- Paying loan fees with exchange funds: points and lender fees paid from the QI account can be taxable; bring those from outside funds when you can.
Run the numbers: try our free Partial 1031 (Boot) Calculator.
