"The client sold the property for 4mil, took down 500K and holds a mtge for 3.5mil."

"as being the amount to use in a 1031 exchange to buy the new rental property which cost 356K"

It seems you understand that 1031 is a type of Banking. But it's supposed to be deferral of tax on gain by the use of the gain to invest it. Your taxpayer is getting the money (violating 1031) by assuming the debt. Carrying the note means there is principal payment portion to your taxpayer. That's why sjrcpa mentioned failed exchange. You also have to know what the gain was on the sale; not just the sale price. The downpayment is not part of the exchange math; again, it's part of banking (how funds are moving). The Exchange is going to use Values and Amounts, not characterization that some amount is considered a downpayment, because a downpayment is part of Payment, just paid early, and against the purchase.

What is supposed to happen for exchange, is that your taxpayer doesn't get to access the funds. By taking back the note for that mortgage, that explains some amount of their sale is not under control of the intermediary and is in fact going to the taxpayer to do with what they want. That makes it outside of the exchange.

You might have a partial exchange or a failed exchange, now that we see some more specific details that apply.