Their gain is over $3m, but you stated: "I then posted the facts regarding the down payment (500K) and the remainder 266K after fees, as being the amount to use in a 1031 exchange to buy the new rental property which cost 356K"

And the math doesn't work here, either.

I would find a local advisor to help. They can work through the details, and perhaps find some sort of deferral in this mess. The internet is not the best resource for working through details that affect each other.