The short answer
At closing, yes, and it is routine. The lender's payoff is taken off the top of the settlement statement before the net proceeds go to your intermediary. The payoff counts as debt relief, which the regulations treat as money received unless you offset it with debt on the replacement or cash you add. What the intermediary should not do is pay off a loan after closing out of exchange funds: once the money is held under the exchange agreement, using it for anything other than buying replacement property is a receipt of cash boot, and a loan against another property is never part of the exchange.
At a glance
| Payoff at closing | Paid through the settlement statement before net proceeds go to the QI |
|---|---|
| Tax character | Liability relief, treated as money received |
| How to offset it | Debt on the replacement, or cash you pay into the purchase |
| One-way netting | New debt offsets debt relief; it does not offset cash you receive |
| Payoff after closing | Exchange funds used for your benefit, so cash boot |
| Where it is reported | Form 8824 line 15, net liabilities assumed by the other party |
| Loans on other property | Not part of the sale; paying them from proceeds is cash boot |
At closing, the payoff comes out before the intermediary holds a dollar
In a deferred exchange the intermediary is treated as transferring your property to the buyer, usually by taking an assignment of your sale contract with written notice to the parties under Reg. section 1.1031(k)-1(g)(4). The closing agent then pays the items on the settlement statement, including the lender's payoff, and wires the balance to the intermediary.
That payoff is part of your amount realized. Reg. section 1.1001-2(a) includes in the amount realized the liabilities from which you are discharged as a result of the sale. The buyer's money retires your loan, and you are treated as if you received that amount.
So the intermediary does not need to pay the lender itself. The question is not who sends the wire but what you do on the purchase side to cover the debt you shed.
The payoff is debt relief, and you cover it with new debt or new cash
Reg. section 1.1031(d)-2 treats liabilities assumed by the other party, or to which your property was subject, as money received. Reg. section 1.1031(b)-1(c) lets liabilities you take on with the replacement offset liabilities you are relieved of.
Reg. section 1.1031(k)-1(j)(3), Example 5, applies the same netting to a deferred exchange: a $30,000 mortgage relieved, a $20,000 mortgage taken on, and $10,000 treated as money received. Cash you add counts against debt relief too. The Form 8824 instructions define net liabilities on line 15 as liabilities assumed by the other party over the total of liabilities you assumed, cash you paid and other property you gave up.
The netting runs one way. Borrowing more on the replacement does not cancel cash you take out, which is the subject of whether more debt offsets cash taken out. Whether you must borrow at all is covered in replacing the mortgage or adding cash.
After closing, exchange funds can buy property, not retire loans
The exchange agreement must limit your right to "receive, pledge, borrow, or otherwise obtain the benefits of money" held by the intermediary until the exchange period ends, under Reg. section 1.1031(k)-1(g)(6). Paragraph (g)(7) lets closing-statement transactional items such as commissions, prorated taxes, recording or transfer taxes and title fees be paid without breaking that limit. A payoff of a loan you still owe after closing is not on that list.
If the intermediary pays a lender for you after closing, you have received the benefit of that money. At best it is taxable boot; if the agreement let you direct such payments at will, the intermediary safe harbor in paragraph (g)(4)(vi) can cease to apply. A loan secured by a different property, a line of credit or a business loan was never relieved by the sale in the first place, as paying off a HELOC or other debts explains.
Exchange funds can, however, go into the purchase of the replacement, including paying the seller's existing loan as part of the price. That is buying property, not paying your debt.
Worked example: a $1,000,000 sale with a $400,000 loan
Hypothetical, round numbers, closing costs ignored; run your own numbers with your CPA. You sell for $1,000,000. The $400,000 mortgage is paid at closing, and $600,000 goes to the intermediary.
Option one: you buy a $1,000,000 replacement with the $600,000 plus a $400,000 new loan. Debt relief of $400,000 is fully offset by $400,000 of new debt, and there is no boot.
Option two: you buy a $700,000 replacement for cash, using the $600,000 and $100,000 of your own money. Net liabilities on line 15 are $400,000 less the $100,000 you paid, so $300,000 of gain is recognized, up to your realized gain.
Option three: after closing you ask the intermediary to pay off a $150,000 loan on another rental. That $150,000 is cash boot, and the remaining $450,000 must still cover a replacement and the debt you shed.
What to do before closing, and where a trust interest helps with the debt
Order the payoff letter early, check it for prepayment terms, and decide before day 45 how you will cover the debt you are shedding. Get replacement financing approved in time, or plan to add cash.
If you cannot or do not want to borrow personally, a beneficial interest in a Delaware Statutory Trust that carries its own non-recourse loan allocates a share of that debt to you; whether it counts is covered in does a DST's loan count as replacement debt.
Related questions
Does the QI need to approve the mortgage payoff at closing?
The payoff is a line on the settlement statement that the closing agent pays from the buyer's funds. Your intermediary reviews the statement because the net amount wired to it is what funds the exchange.
Is the mortgage payoff taxable?
Only to the extent it is not offset. Debt relief is treated as money received, so it is taxed unless you take on at least as much debt with the replacement or pay in matching cash.
Can I pay down the mortgage before I sell to reduce the debt I must replace?
Paying with outside cash before the sale lowers the debt relieved at closing. It changes the mix of cash and debt you need on the replacement, not the total purchase price you need to avoid boot.
Can exchange funds pay off the loan on my replacement property later?
No. Once you own the replacement, exchange funds cannot be used to pay your own debt. Use them only toward the purchase price at closing.
What about a prepayment penalty on my old loan?
It appears on the settlement statement with the payoff. Whether it is an exchange expense that reduces boot is a question for your CPA, because Reg. section 1.1031(k)-1(g)(7) lists typical closing items without naming it.
Sources
Checked against these publications on September 30, 2026. Rules and figures change; confirm the current version with your CPA or attorney before you act. This page is general information, not tax or legal advice.