Can do 1031 exchange while downsizing assets?

[Henri Meli]

Had a discussion with other investors today about 1031 and thought I run it here for opinions. John is an investor in my group.

4 years ago, John did a 1031 exchange from a SFR into a MF and took on $1MM debt on a $1.5MM asset.

Today, the asset is valued at around 3.5MM based on NOI. Meaning John now has over $2.5MM of equity into the asset. John wants to de-risk his portfolio, eliminate debt and downsize. He is thinking about the following options.

0. Refinance. John isn't interested, as he believes assets are overvalued and taking on more debt is not an option.

1. Sell and pay taxes on realized gains. (John is comfortable with paying all the taxes).

2. Sell the asset at estimated value ($3.5MM), then exchange it into a smaller smaller MF (similar to current) worth $1MM. This asset is more stabilized and John only wants the monthly payments. John then wants to use the remaining gains and purchase a beach condo valued at $300k (rent or second home).  John wants to cash out whatever is remaining (and is ok on the taxes).. John does not plan to take on any debt for the new transactions.

Questions: Is the transaction in 2. legal ?