When using a Section 1031 Exchange transaction to defer taxes, the Exchanger has only 45 days from the day of closing on its relinquished property to identify 1031 replacement property or multiple replacement properties.
Below are three rules for identifying multiple section 1031 exchange replacement properties along with examples of each rule.
WARNING: Section 1031 and the IRS regulations thereunder have strict requirements for the identification of replacement property.
Identification of all 1031 replacement propertymust be made in writing, must be signed by the Exchanger, andmust be delivered to the Qualified Intermediary(Liberty 1031, LLC) on orbefore midnight of the 45th day.
The Exchanger may identify any type of investment or business real property in the USA, including a single-family rental, apartment building, hotel, office building, warehouse, vacant land, shopping center, etc.
The Exchanger/Taxpayer may not identify replacement property or amend its identification after the 45th day has expired.
The Exchanger may identify more than one property, as follows:
(1) The Exchanger may identify as many as three (3) properties, regardless of their total value (known as the “3-Property Rule”) See Example # 1 below; OR
(2) The Exchanger may identify any number of properties provided their aggregate fair market value on the 45th day does not exceed 200% of the aggregate fair market value of all of the Exchanger’s relinquished property on the date of its transfer (known as the “200% Rule”) See Example #2 below; OR
(3) The Exchanger may receive, by the end of the Exchange Period, Replacement Property which the Fair Market Value of, is at least 95% of the aggregate Fair Market Value of all of the Replacement properties identified (known as the” 95% Rule”) See Example #3 below.
The Exchanger is not required to acquire all the property it has have identified. Therefore, many gurus in our industry recommend that the Exchanger identify alternative properties should the closing on the Exchanger’s preferred property fail for any reason. Any property acquired prior to the 45-day Exchanger’s identification expiring, counts as an identified property.
EXAMPLE #1 – 1—3 PROPERTY RULE: Mr. and Mrs. Trembling(Exchangers) sell their investment property that they have owned for 17 years for the sum of $695,000.00. They, within 45 days of the relinquished transaction, e-mail to their Qualified Intermediary a list of three (3) properties for the following amounts: Property # 1: $1,200,000.00; Property #2: $500,000.00; Property # 3; $400,000.00.
As long as the Exchangers purchase property of equal or more value than their relinquished property ($695,000.00) any tax they may have owed will be deferred. There is NO dollar amount limitation on the properties they have identified. The only limitation they have using this rule is that they can only identify 3 properties.
EXAMPLE #2 – 200% RULE: Mr. and Mrs. Anderson(Exchangers) sell their investment property that they have owned for 3.5 years for the sum of $500,000.00. Within the 45-day time limit, they e-mail to their Qualified Intermediary, the following list of possible Replacement Properties: #1: $150,000.00; #2: $300,000.00; #3: $250,000.00; #4: $100,000.00; and #5: $199,000.00.
The Exchangers are allowed to identify any number of properties, but they cannot total together more than 200% of what they sold.
The 5 properties they identified combined total: $999,000.00, which is under the $1,000,000.00) they would be allowed to identify and therefore their Identification is valid. They do not have to purchase all of these properties, but if they want to defer all of their gains, they must obtain at least $500,000.00 of replacement property.
EXAMPLE #3 – 95% RULE: Mr. Thomas Franklin (Exchnager)sells his investment property for the tidy sum of $800,000. He identifies the following properties as possible replacement properties: #1: $600,000; #2:$ 300,000; #3: 900,000; #4: 700,000 and #5: $200,000.
The total valuation of all the properties together is: $2,700,000.
He cannot use the 200% rule because he has identified more than 200% of his relinquished property’s selling price ($800,000 x 200% = $1,600,000). But he can still use the 95% rule.He must purchase 95% of the valuation price of the properties he identified.That would be: $2,565,000 ($2,700,000 x 95% = $2,565,000). If he purchases less than the 95%, his 1031 exchange will be disqualified.
After reviewing the above 3 Rules for Identification, most Exchangers select the 3 Property rule, because it is a lot easier. It has no dollar amount restrictions, but the exchanger is limited to only 3 properties for identification purposes.
Stephen Wayner is an attorney, Certified Exchange Specialist (CES), and Managing Director of Liberty 1031. Mr. Wayner is recognized as a leading authority on the subject of 1031 exchange transactions. He is a current board member of the Federation of Exchange Accommodators (FEA) and is the author of numerous books and articles on 1031 Exchanges and real estate investing.
Mr. Wayner has been cited as an expert on 1031 Exchanges in publications including USA Today, NewYork Times, Business Week, and The Wall Street Journal among many others.