Partial 1031 at $600K Gain: Defer $400K, Cash $200K

The decision: Marcus has a $600K gain and needs $200K in cash

Marcus is single, files in California, and is selling a Sacramento fourplex he has owned for 14 years. He bought it for $520,000, claimed $150,000 of depreciation along the way, and is selling for $980,000 with the mortgage now down to $300,000. After the qualified intermediary nets out the sale, his realized gain is roughly $600,000 ($980,000 sale price minus his $380,000 adjusted basis, which is the original cost reduced by depreciation, simplified for selling costs).

Marcus wants to keep investing — but he also wants $200,000 in cash to pay off a separate loan and fund a gut renovation on a new building. A full 1031 defers every dollar of the $600,000 gain but leaves him with zero liquidity. Selling outright hands him the cash but triggers tax on all $600,000. The partial 1031 is the middle path: defer $400,000 of the gain, recognize the $200,000 he cashes out, and pay tax only on that cash portion.

Here is the resolution. Because Marcus fully replaces his $300,000 mortgage and adds no new cash, his taxable boot is exactly the $200,000 he takes out. His recognized gain is the lesser of his $600,000 realized gain or the $200,000 boot — so $200,000. The other $400,000 rides into the replacement property tax-deferred. The tax on that $200,000, sequenced correctly, comes to about $55,100 federal — not the $40,000 a flat 20% rate implies, because recapture is stacked on first.

How a partial 1031 actually works

IRC §1031 lets you defer gain when you exchange real property held for investment or business use for other like-kind real property. Since the TCJA in 2017, only real property qualifies — no more equipment, vehicles, or personal property exchanges. The deferral is not all-or-nothing. You can reinvest part of the proceeds and keep part as cash; the part you keep is the only part that gets taxed.

The mechanics every partial exchange runs on:

1. A Qualified Intermediary (QI) holds the proceeds. You cannot touch the sale proceeds, or the entire exchange is disqualified. The QI receives the funds at closing, holds them, and disburses to buy the replacement property — releasing only the cash you intentionally pull out as boot.
2. The 45-day identification clock starts at closing. You must identify replacement property in writing within 45 days of relinquishing the old property.
3. The 180-day closing clock. You must close on the replacement within 180 days of the sale (or your tax filing deadline, whichever is earlier).
4. The equal-or-up rule sets your boot. Under Treas. Reg. §1.1031, to defer fully you must buy replacement property of equal or greater value AND replace the debt you paid off. Whatever you fall short by — in cash kept or debt not replaced — becomes taxable boot.

For Marcus, the QI releases $200,000 to him and applies the rest toward a replacement building large enough to absorb the deferred equity and re-leverage the $300,000 mortgage. That release is his deliberate boot.

Calculating taxable boot: cash plus net debt relief

Boot is not just cash. It is cash received plus any net debt relief, reduced by new cash you add and exchange expenses. The formula:

Boot = cash received + net debt relief − new cash added − exchange costs

Recognized gain = the lesser of realized gain or net boot.

This is where investors get blindsided. Say Marcus had taken zero cash but bought a replacement property with only a $200,000 mortgage instead of replacing his full $300,000. That $100,000 of debt he no longer owes is mortgage boot — phantom income. He would owe tax on $100,000 he never received in cash. The fix is to either re-borrow up to the old debt level on the replacement property or add $100,000 of fresh cash to offset it. Marcus avoids this by fully re-leveraging, so his only boot is the deliberate $200,000.

The ordering trap: recapture is taxed FIRST on the recognized $200K

Now the part nearly every “just pay 20%” estimate gets wrong. When you recognize gain in a partial 1031, the recognized gain is sourced from depreciation recapture before capital gain. The unrecaptured §1250 gain — the depreciation you wrote off over the years — comes off the top of the recognized amount and is taxed at a maximum rate of 25%, not the 15% or 20% long-term capital gains rate.

Marcus claimed $150,000 of depreciation. So of his $200,000 recognized gain, the first $150,000 is unrecaptured §1250 gain taxed at up to 25%. Only the remaining $50,000 is taxed at the long-term capital gains rate — and because his total taxable income lands him in the top capital gains tier, that piece is taxed at 20%. On top of both, the 3.8% Net Investment Income Tax (IRC §1411) applies because his modified AGI is far above the $200,000 single threshold.

The math, sequenced correctly

That is $55,100 federal on the $200,000 he pulls out — an effective rate of about 27.6%, well above the flat 20% a quick estimate suggests. The recapture-first ordering is the entire reason. A blended “20% of $200,000 = $40,000” guess understates the bill by roughly $15,000. The recapture layer alone ($37,500 on the first $150,000) is more than the entire flat-20% estimate would put against the LTCG-only piece.

California adds its own layer: the state taxes capital gains and recaptured depreciation as ordinary income at rates up to 13.3%. On $200,000 of recognized California-source gain, that is roughly another $26,000 — California does not have a preferential capital gains rate. Marcus’s all-in cost to access $200,000 of cash is closer to $81,000. The $400,000 he defers carries no state or federal tax this year.

The full comparison: defer all, cash all, or split

Selling outright recognizes the full $600,000: $150,000 of recapture at 25% ($37,500), $450,000 at 20% LTCG ($90,000), plus the 3.8% NIIT under §1411. NIIT applies to the lesser of net investment income or MAGI over the $200,000 single threshold, so on this recognized gain it adds roughly $22,800 — landing the full-sale federal bill near $150,300 before California tax. The partial 1031 cuts that federal bill by roughly $95,000 while still freeing the $200,000 Marcus needs.

What most investors miss

• “Boot is taxed at my capital gains rate.” No. Recapture comes first at up to 25%. On a property with heavy accumulated depreciation, most of your recognized gain can be recapture, not LTCG. The more you depreciated, the more the recapture-first rule costs you on the cash-out.
• “I only owe tax if I take cash.” Net debt relief is boot too. Buy a smaller mortgage than you paid off and you create phantom taxable income with no cash to pay it. Match or exceed your old debt, or add cash to plug the gap.
• “A partial exchange is riskier than a full one.” The deferral mechanics are identical — same QI, same 45/180-day clocks. You are simply choosing to recognize a slice on purpose. Recognized gain can never exceed your realized gain, so there is no surprise above the boot you elected to take.
• “Forgetting the NIIT.” At Marcus’s income, the 3.8% NIIT under IRC §1411 applies to the recognized gain and adds $7,600. Quotes that cite only the 25% and 20% rates understate the real cost on every high-income transaction.

How to size the boot to a specific cash need

The planning lever is to work backward from the cash you actually need, not the gain you happen to have. Marcus needs $200,000, so he structures the exchange to release exactly that — no more. The steps:

1. Define the cash target. $200,000 here. This becomes the intended boot.
2. Confirm replacement value covers the rest. Replacement property must be worth at least the relinquished value minus the $200,000 taken — otherwise extra value boot appears.
3. Replace the debt. Re-leverage the replacement property to match or exceed the $300,000 mortgage that was discharged, eliminating mortgage boot.
4. Layer the tax correctly. Recapture first (up to 25%), then LTCG (15%/20%), then 3.8% NIIT. Reserve the tax out of the $200,000 you receive so the cash is genuinely net.

The decision lever

The number that decides this is your accumulated depreciation relative to the cash you want. Because recapture is sourced first, an investor who depreciated heavily pays a 25% rate on most of the boot — so the marginal cost of pulling cash is higher than the headline LTCG rate. If your recognized gain would be mostly recapture, pull only the cash you truly need and let the rest defer. If you need a fixed amount like Marcus’s $200,000, size the boot to that exact figure, fully replace your debt, and reserve roughly 28% federal (plus your state rate) out of the proceeds before you spend a dollar of it.