Identification and acquisition of potential like-kind replacement properties in a 1031 exchange are subject to strict requirements. Section 1031 of the Internal Revenue Code (“IRC”) stipulates that in order to defer capital gains taxes through a 1031 exchange, investors must identify potential replacement properties within 45 days.
It can be challenging for investors to identify a specific replacement property within 45 days of the sale of their previous property. In light of this, the IRC permits investors to identify multiple potential replacement properties. Here is a description of the three identification rules, as well as an explanation of why you might choose one over the others.
What is the rule for identifying three properties?
According to the Three Property Identification Rule (“Three Property Rule”), you may identify a maximum of three (3) potential like-kind replacement properties regardless of their fair market value.
The Three Property Rule is currently the most popular 1031 exchange strategy. If you have a reasonable assurance that you will be able to acquire a specific property that meets your like-kind requirements, you will likely opt for the Three Property Rule. Using this strategy, you could acquire all three of the identified like-kind replacement properties as part of your 1031 exchange, but the majority of investors only acquire one of the three properties. The second and third properties are merely “backup” properties in the event that you are unable to acquire the first property.
WHAT IS THE 200% OF FAIR MARKET VALUE IDENTIFICATION REGULATION?
The 200 percent of Fair Market Value Identification Rule (“200 percent Rule”) states that you may identify an unlimited number of like-kind replacement properties so long as the total fair market value of all identified like-kind replacement properties does not exceed 200 percent of the total (aggregate) net sales value of the relinquished property(ies) sold in your 1031 exchange.
For instance, if you sold relinquished property(ies) for $2,000,000, you could identify as many like-kind replacement properties as you wish so long as the total fair market value does not exceed $4,000,000 (200% of $2,000,000). The total fair market value of these identified properties is based on the fair market value of each property at the end of your identification period, which is 45 days after the sale of your relinquished property.
If you are attempting to diversify your investment portfolio and wish to acquire multiple replacement properties, you may choose this strategy. If you intend to purchase four or more properties, the Three Property Rule is insufficient. Or, even if you only intend to purchase two replacement properties, it may be prudent to have more than one “back-up.” Again, the Three Property Rule would be insufficient in this situation. In addition, if you are uncertain about your preferences for a replacement property, you can identify a handful of properties (with fair market values within the 200 percent allowance) and then take additional time to make a decision.
It is likely that if you identify more than three properties, at least one of them will meet your preferences and requirements. Similarly, your 45-day identification period may be coming to a close before you have had adequate time to investigate properties and make arrangements. Again, you could quickly identify a handful of properties and then take your time deciding which is the best option. This strategy would be advantageous in a variety of similar circumstances.
WHAT IS THE IDENTIFICATION EXCEPTION FOR 95%?
The 95 percent Identification Exception (“95 percent Exception”) allows you to identify an unlimited number of potential like-kind replacement properties with an unlimited total (aggregate) fair market value, provided you acquire and close on 95 percent of the identified value.
This exception can be useful if you have attempted to identify replacement property in accordance with the 200 percent Rule, but have exceeded the 200 percent limit at the conclusion of the identification period. Because the fair market value of the identified properties is determined at the end of the identification period, investors are sometimes surprised when the value of a property increases substantially between the time they identified the property and the end of the identification period. If not for the 95 percent Exception, the investor’s exchange would have been disqualified for noncompliance with the identification period regulations. Nonetheless, if the investor acquires at least 95% of the fair market value of the identified properties, the exchange can still be completed.
In other situations, investors may be required to identify more than three properties and more than 200 percent of the property’s sales price. In this instance, the 95 percent Exception is required. It is advantageous to have options, but this exception can present difficult challenges. If you fail to acquire and close on at least 95% of the identified like-kind replacement properties, the entire 1031 exchange transaction will be disallowed.
Nota: If 1031 exchange investors identify more properties than permitted by the Three Property Rule or the 200 Percent Rule and are unable to apply the 95 Percent Exception, it will be as if no properties were identified.
The 1031 exchange is disqualified if investors fail to identify properties within the 45-day identification period.
To qualify as replacement properties in a 1031 exchange, identified properties must be acquired prior to the exchange period deadline, which is 180 days after the sale of the relinquished property.
Properties that are not included on the list of identified replacement properties will not be considered valid replacement properties for purposes of satisfying the 1031 exchange requirements.
HOW TO DETERMINE SUBSTITUTE PROPERTIES
Replacement properties that you are considering for acquisition in your 1031 exchange must be identified to your Qualified Intermediary (“QI”) no later than the 45th calendar day following the closing of the sale of your relinquished property. Due to the fact that the deadlines are based on calendar days, there are no extensions for weekends or holidays that fall within your identification period.
To identify potential replacement properties for your QI, you must submit a signed, written document that describes the properties without ambiguity. The property description may include a legal description, street address, or unique name.
If you wish to revoke the identification of a candidate replacement property, you must also submit a signed, written document that unambiguously identifies the property from the list of identified properties.