1 Like-Kind Property
Like-kind property means that both the original and replacement properties must be of “the same nature, even if they differ in grade or quality.” To further clarify, you can not exchange industrial equipment for a multi-family property, because they are not the same asset. As it relates to real estate, you can exchange almost any type of property as long as it’s not personal property. Here’s an example:
Note: It’s important to understand that the original and replacement property must be within the United States to qualify under section 1031 of the IRS code.
Here’s one more cool fact about 1031 - Exchanges can include more than two properties. For example, you can exchange one property for multiple replacement properties. You can also exchange multiple properties for one large valued property. You may do this as long as the new properties are like your original properties. We highly recommend getting a top-notch intermediary to assist you and we can surely introduce you.
2 Investment or for the purpose of business only
A 1031 exchange is not applicable for personal property, but rather for investment or business property only. In short, you can’t swap your primary residence for another.
Here are three examples:
3 Greater or Equal Value
According to the IRS requirements, in order to completely avoid paying any taxes upon the sale of your property, the net market value and equity of the property purchased must be the same as or greater than the property sold. Otherwise, you will not be able to defer 100% of the tax. Here’s an example:
Let’s say you have a commercial property valued at $2 million and a mortgage of $500,000. In order for you to receive the full benefit of the 1031 exchange, the new property or properties you purchase need to have a net worth value of at least $2 million and you’ll have to bring over at least $500,00 in debt/mortgage.
Please note here that the $2 million + value and the $500,000 debt can go towards one multi-family or three different properties with a total value of $2 million +. Finally, it’s good to note that your acquisition costs like inspections, broker commissions, etc do apply toward the total cost of the new property.
4 Must not receive “Boot”
In order for the exchange to be completely tax-free, a taxpayer must not receive “boot”. Any boot received is taxable to the extent of the gain realized on the exchange. What does this mean in lamens terms? You can execute a partial 1031 exchange for which, the new property is of lesser value, however, this will NOT be 100% tax free. The difference here is called “Boot,” which is the amount you will have to pay capital gains on.
Please note that this option is completely fine and is often used when the seller/investor wants cash and is willing to pay the necessary taxes to do so. Here’s an example:
Let’s use say the investor sold their $2 million property. He or she has identified the new property they want to exchange into under section 1031 and it’s worth $1.5 million. The investor would then need to pay capital gains tax on $500,000 or “boot”.
5 Same Tax Payer
Under section 1031 of the IRS exchange code, 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.
There is an exception to this rule, which is in the case of a single member limited liability company or a pass-through to the member. As a result, the single member limited liability company may sell the original property and that sole member may purchase the new property in their individual name or another name for that new property. Here’s an example: Single member “John Smith LLC” is John Smith. The LLC can then sell the property owned by the LLC and because Mr. Smith is the only member of the LLC, he can purchase another property in his name. This would be compliant with the 1031 exchange code.