An Investor’s Guide to the 200% Rule in 1031 Exchanges
A 1031 Exchange is a type of real estate transaction used by real estate investors and real estate agents to defer capital gains taxes by swapping one like-kind investment property for another. The transaction gets its name from IRS Internal Revenue Code Section 1031 and can be a very effective strategy for investors to grow their capital, tax deferred, over time.
In this article, we are going to discuss what the 200% Rule in a 1031 Exchange is, how it works, and why it is important to understand it for tax deferral benefits. By the end, investors will have all of the information needed to understand if the 200% Rule is a good fit for their own investment strategy.
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What is a 1031 Exchange?
In order to provide the proper context for the 200% rule, it is first necessary to describe what a 1031 Exchange transaction is.
As described above, 1031 Exchange is a commercial real estate investment strategy that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sale proceeds into another property that is “like kind” to the one that was sold. To illustrate how it works, consider a very simple example.
Suppose an investor bought a property for $5M and then sold it 5 years later for $5.25M. The difference between the purchase price and the sales price, $250,000, is classified as a “gain on sale” and it is taxable. Under a 1031 Exchange, investors can defer this tax bill indefinitely as long as they use the sale proceeds to purchase another, like kind property.
To complete a 1031 Exchange, there are a number of rules that investors must abide by and one of the most important concerns the value of the new property and it is known as the 200% rule.
What is the 200% Rule in a 1031 Exchange?
To understand the 200% rule, think of an investor that would like to sell an exchange property and defer the capital gains taxes associated with the sales proceeds by purchasing one or more like-kind replacement properties. Sequentially, there are a number of steps that must be considered.
The first option is for the investor to identify up to three replacement properties regardless of the sales price of those rental properties. But, this will not work for an investor who wants to identify more than three properties.
The next option is for investors to consider the 200% Rule, which states that an investor/taxpayer can identify more than 3 potential replacement properties provided the replacement property’s combined value does not exceed 200% of the fair market value of the relinquished property.
It is important to note that this process must include a legal description of the sale, and the use of a qualified intermediary such as: a CPA with 1031 experience, a real estate attorney, a bank like Wells Fargo, or the person obligated to transfer the replacement property to the investor. In addition, all other identification rules must be followed.
Example of Using the 200% Rule
To illustrate how the 200% rule works, consider the following example.
Suppose a commercial real estate investor sells a property for $1 million and all accounts are closed in escrow starting the 45-day identification period. Following the sale, they could then identify five properties each worth $400,000 for a total aggregate value of $2 million. Although five identified properties exceed the Three Property Rule, the investor has identified replacement properties in which the combined value does not exceed 200% of the relinquished property’s value of $1 million.
Benefits of the 1031 Exchange 200% Rule
The primary benefit of the 200% rule is that it provides an investor with an opportunity to diversify their real estate investment portfolio on a number of levels, by property type., location, or tenant(s).
In the example above, suppose the investor exchanges an office building for two multifamily properties, a retail center, a warehouse, and a self-storage property, all of which have different locations and tenants. By doing this, the investors have significantly diversified their portfolio and hopefully reduced their risk in the process.
Determining if Using the 200% Rule is the Right Choice
An easy rule of thumb to determine if the 200% rule is appropriate is for an investor to ask themselves, “how many replacement properties do I want to identify?” If the answer is more than three, the 200% rule may be a viable solution.
Summary of the 200% Rule in a 1031 Exchange
A 1031 Exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as the sales proceeds are reinvested into another “like kind” property.
There are a number of rules that investors must follow with regard to the replacement property identification process. For example, the 3 property rule states that investors can identify up to three replacement properties. But, if they want to identify more than, they must rely upon the 200% rule.
The 200% rule allows investors to identify more than three replacement properties as long as the aggregate value does not exceed 200% of the value of the property sold.
Utilizing the 200% rule can be an excellent way for investors to diversify their investment portfolios by property type, location, geography, and tenant.
A 1031 Exchange is a complex transaction with a number of rules that must be followed. Violating any of them can result in a taxable gain, so it is always a good idea to consult a CPA or tax advisor to determine if one is suitable for a given set of circumstances.
Interested in Learning More?
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