There are very specific requirements for identifying and acquiring potential like-kind replacement properties in your 1031 exchange transaction. Section 1031 of the Internal Revenue Code (“IRC”) specifies that investors must identify candidate replacement properties within a 45-day period to defer capital gains taxes through a 1031 exchange.
It can prove to be difficult for investors to identify their specific replacement property within 45 days of selling their relinquished property. For this reason, the IRC provides allowances for investors to identify multiple potential replacement properties. Here is a description of the three identification rules along with an explanation of some of the reasons you might opt for one strategy over another.
What is the Three Property Identification Rule
The Three Property Identification Rule (“Three Property Rule”) states you can identify a maximum of three (3) potential like-kind replacement properties regardless of the fair market value of those properties.
The Three Property Rule is the most popular strategy by 1031 exchange investors today. If you have a reasonable assurance that you can acquire a specific property that suits your like-kind requirements, then you are likely to opt for the Three Property Rule. With this strategy, you could acquire all three of the identified like-kind replacement properties as part of your 1031 exchange, but most investors only purchase one of the three properties. The second and third identified properties merely act as ‘back-up’ replacement properties in case you do not or cannot acquire the first property.
What is the 200% of Fair Market Value Identification Rule
The 200% of Fair Market Value Identification Rule (“200% Rule”) states you can identify an unlimited number of like-kind replacement properties as long as the total (aggregate) fair market value of all identified like-kind replacement properties does not exceed 200% of the total (aggregate) net sales value of the relinquished property(ies) sold in your 1031 exchange.
For example, if you sold relinquished property(ies) in the amount of $2,000,000, you would be able to identify as many like-kind replacement properties as you want as long as the total fair market does not exceed $4,000,000 (200% of $2,000,000). The total fair market value of these identified properties is determined by the fair market value of each property at the close of your identification period, which is 45 days after the close of the sale of your relinquished property.
One reason you may opt for this strategy is if you are trying to diversify your investment portfolio and wish to acquire more than one replacement property. If you are planning to acquire four or more properties, the Three Property Rule is not sufficient for you. Or, even if you are only planning to acquire two replacement properties, it might be a good idea to have more than one ‘back-up.’ In this case, again, the Three Property Rule would be insufficient. Additionally, if you are unsure about your preferences for a replacement property, you can identify a handful of properties (with fair market values within the 200% allowance) and then take some extra time to decide what you want.
Identifying more than three properties would likely provide you enough options so that at least one of them would suit your preferences and needs. Similarly, maybe your 45-day identification period is coming to a close before you have had sufficient time to research properties and make arrangements. In this case, you could, again, identify a handful of properties in a hurry and then take your time determining the best option for you. There are many scenarios like these in which this strategy could benefit you.
What is the 95% Identification Exception
The 95% Identification Exception (“95% Exception”) states you can identify an unlimited number of potential like-kind replacement properties with an unlimited total (aggregate) fair market value as long as you acquire and close on 95% of the value identified.
This exception can come in handy when you have attempted to identify replacement property according to the 200% Rule, but have exceeded the 200% allowance at the close of the identification period. Because the fair market value of the identified properties is determined at the close of the identification period, there are times when investors become surprised after a property’s value significantly increases from the time they identified the property to the time the identification period ended. If not for the 95% Exception, the investor’s exchange would be disqualified because the investor was out of compliance with the regulations of the identification period. However, in this case, the investor could still complete their exchange if they acquire at least 95% of the fair market value of the identified properties.
In other circumstances, investors may need to identify more than three properties and more than 200% of the sales value of the relinquished property. In this situation, the 95% Exception becomes necessary. It is good to have choices, but be careful with this exception; it can present some tricky problems. If you do not acquire and close on at least 95% of the value of the identified like-kind replacement properties, the entire 1031 exchange transaction will be disallowed.
Things to Note:
- If 1031 exchange investors identify more properties than allowed by the Three Property Rule or the 200% Rule and cannot apply the 95% Exception, it will be as if no properties were identified.
- If 1031 exchange investors do not identify properties within the 45-day identification period, the 1031 exchange becomes disqualified.
- Identified properties must be acquired before the exchange period deadline, 180 days following the close of the sale of the relinquished property, to qualify as replacement properties in the 1031 exchange.
- Properties not included on the list of identified replacement properties will not be considered valid replacement properties to satisfy the requirements of the 1031 exchange.
How to Identify Replacement Properties
Replacement properties that you are considering for acquisition in your 1031 exchange should be identified to your Qualified Intermediary (“QI”) and must be identified no later than midnight of the 45th calendar day following the close of your relinquished property sale transaction. Because the deadlines are based on calendar days, there are no extensions for the weekends or holidays that fall within your identification period.
To identify potential replacement properties to your QI, you must provide a written and signed document that unambiguously describes the properties you wish to identify. The property description may include a legal description, street address, or distinguishable name.
If in the case you wish to revoke the identification of a candidate replacement property, you must also provide a written and signed document that unambiguously describes the property that you wish to remove from the list of identified properties.