How does 1031 debt-replacement work for an owner-user 1031 exchange?

1031 debt-replacement mechanics on owner-user replacement properties

Debt replacement rule: under IRC §1031 like-kind exchange, the replacement property must have debt equal to or greater than the debt on the relinquished property to fully defer capital gain. A debt shortfall (the 'mortgage boot' shortfall) triggers gain recognition equal to the shortfall, even if all cash proceeds are reinvested.

Owner-user complication: SBA 504 and 7(a) sizing depends on the operating business's cash flow and the occupancy test, not just the replacement property value. The replacement debt amount is sometimes constrained by SBA sizing rules, not by the sponsor's preference.

Conventional alternative: sponsors who need to hit a specific debt level for §1031 compliance sometimes use conventional bank financing instead of SBA, even though SBA pricing is better. The trade-off is between tax deferral and financing cost.

Coordination with qualified intermediary (QI): the QI holds the relinquished-property proceeds during the 45/180-day exchange window. Lender funding on the replacement must close within the 180-day window. Sponsor needs to engage QI, lender, and counsel pre-relinquishment to confirm financing timing.

Cash boot: any cash received that doesn't go to acquire replacement property is 'cash boot' and is taxable. Loan proceeds at the replacement closing that exceed acquisition cost can also create boot.

Sponsor playbook: model the replacement debt level pre-relinquishment, identify financing constraints (SBA sizing limits, conventional bank LTV), and confirm with tax counsel that the resulting structure achieves the sponsor's deferral objective. Not tax advice, engage tax and exchange counsel from kickoff.