I have a property I want to 1031 exchange that presently has a mortgage on it that I want to exchange into a larger, more expensive property without paying capital gains or recapture at this time. It is my understanding this can be done provided we follow the rules, which I have read on IRS.gov.

That said, one question remains and I've heard two conflicting answers from sources I trust on this question: Can I use the proceeds from the sale of the property to pay off the mortgage, or must I first pay off the entire mortgage and then sell the property and transfer all the proceeds to the intermediary (escrow) agent to hold for purchase of the replacement property? I do not want to do anything that causes me to receive "Boot" (i.e. funds) that would jeopardies the exchange.

The IRS guidelines I found online didn't offer much clarity. Go figure. What saith the wisdom of the board of advisors?

There is a great deal of info out there that it misleading on debt and 1031's. It will be easier for me to give you an example.

So lets say you are selling a SFH that is worth 150K and you owe 50K on it. When you sell the place 10K will go towards closing cost so your closing statement on leg one will show $150K - 50K (mortgage that will be PIF) - 10K (closing cost) = 90K being transferred to your Financial Intermediary (FI).

You will have 45 days to ID and 180 days to close from the date of the first leg closing.

Assuming you want to fully utilize the 1031 benefit, you will need to incur at least the same amount of debt that you had before plus any closing cost that you had. (But there is also a work around that I will address a bit later)

So you find a nice entry level commercial units as a replacement for $400K You think you can talk them down though to $350 for the place. You go to your local bank and let them know that your FI is sporting 90K that you want to use as a down payment on a that is $350K. The bank looks at the DSCR and the LTV and approves the place.

So you close this deal and leg two is done. You didn't put any "boot" into your pocket so you increased the debt from $50K to $260K. The banks appraisal comes in at $365K which says you know how to haggle.

Your LTV and DSCR ratios are good enough that you are able to also get a small second LOC on the place for 20K. Since this is occurring after your leg two is closed, that money is not taxed.

So using this example you are using a 1031 to grow the business. You can also structure the second leg so you are preserving wealth. Your class C house that you sold has been fixed up nice at $150, but now you are doing a valued added play with a beat up class B place. It is available for $175K since it is an estate sale. You use the 90K down payment and now have a loan for $85K. The bank is willing to give you a LTV ratio of 20% so they give you a HeLOC of $50K that you can use to make this class B unit even nicer than your class C unit. This HeLOC has to occur after the closing date though.

The mortgage gets paid off by escrow and then the funds left over are transferred to your accommodator.

Here are some twist to how to do 1031's

1) Already have a commercial place and looking to sell it as there is too much maintenance ahead? Sell the building and execute a land lease instead and use the building funds for the first leg. This works awesome for NNN properties.

2) Place your property into a trust and sell fractional ownership so your replacement property is just $1 over the sales prices of leg one. This works well for selling off store fronts

3) Move into your property 2 of the past 5 years so you qualify for a 121 exchange instead of a 1031 exchange.

Very tricky. When the property is sold, in order to transfer clear title to new owner mortgage must be paid off. If it is paid off during closing, you have received "boot" and there will be tax consequences.

I've done a number of these over the last 3 years. To answer the original question by Sid: No, you don't have to pay your existing mortgage off before closing when you are doing a 1031 Exchange. The mortgage is paid off at closing as usual

You do have to find a property that is more expensive than the one you are selling (including it's mortgage) to exchange into so you don't have any boot on which to pay cap gains. This way you can defer the gains to the next time or keep deferring indefinately.