Like-Kind Property Definition: Like-Kind property is a very broad term which means that both the original and replacement properties must be of “the same nature or character, even if they differ in grade or quality.” (4) In other words, you can’t exchange farming equipment for an apartment building, because they’re not the same asset. In terms of real estate, you can exchange almost any type of property, as long as it’s not personal property.

For example:

Exchanging an apartment building for a duplex would be allowed.

Exchanging a single family rental property for a commercial office building would be allowed

Exchanging a rental property or vacation rental for a restaurant space would be allowed.

EXCEPTION: It’s important to note that the original and replacement property must be within the U.S. to qualify under section 1031.

For example:

1. If you moved from California to Georgia, you could not exchange your primary residence in California for another primary residence in Georgia.

2. If you were to get married, and move into the home of your partner, you could not exchange your current primary residence for a vacation property.

3. If you were to own a single-family rental property in Idaho, you could exchange it for a commercial rental property in Texas.

For example, let’s say you have a property worth $2,000,000, and a mortgage of $500,000. To receive the full benefit of the 1031 exchange, the new property (or properties) you purchase need to have a net worth of at least 2 million dollars, and you’ll have to carry over at least a $500,000 mortgage. It’s important to note that the $2,000,000+ value, and $500,000 mortgage, can go towards one apartment building or three different properties with a total value of $2,000,000+. (FYI: Acquisition costs, such as inspections and broker fees also apply toward the total cost of the new property.)

A Taxpayer Must Not Receive “Boot” from an exchange in order for a Section 1031 exchange to be completely tax-free. Any boot received is taxable to the extent of gain realized on the exchange. In other words, you can carry out a partial 1031 exchange, in which the new property is of lesser value, but this will not be 100% tax free. The difference is called “Boot,” which is the amount you will have to pay capital gains taxes on. This option is completely okay, and often used when a seller wants to make some cash, and is willing to pay some taxes to do so.

An example of this would be if your original property is sold for $2,000,000 and the property you wish to exchange under section 1031 is worth $1,500,000, you would need to pay the normal capital gains tax on the $500,000 “boot.”

The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. However, an exception to this rule occurs in the case of a single member limited liability company (“smllc”), which is considered a pass-through to the member. Therefore, the smllc may sell the original property, and that sole member may purchase the new property in their individual name.

For example, the single member of “Sally Jones LLC” is Sally Jones. The LLC can sell the property owned by the LLC, and because Sally Jones is the sole member of the LLC, he can purchase property in his name, and be in compliance with the 1031 code.

An exception to this is known as the 200% rule. In this situation, you can identify four or more properties as long as the value of those four combined does not exceed 200% of the value of the property sold.

As you might realize, there are many rules and qualification requirements that you must comply with in order to perform a successful 1031 exchange. To sum things up, the biggest advantage of a 1031 exchange is that you can avoid having to pay capital gains taxes on the sale of an investment property. This can be a huge benefit for real estate investors who know which markets are primed to grow next. It can also be a huge downfall for beginning investors, or those who don’t understand the changing real estate landscape. If you don’t, you risk falling victim to one the biggest disadvantages of a 1031 exchange–the reduced basis for depreciation on the replacement property.

This means that if you were to sell your replacement property, even at a deficit, you would still be accountable for the capital gains on the initial property. In other words, if you want to maximize the benefits of your exchange, it’s important that you choose your replacement property (or properties) wisely, investing in a market that has good potential for growth in the future.