The name “1031 Exchange” implies that it is a type of real estate transaction where one property is “exchanged” for another. In many cases, this is true, but not always. Under certain circumstances an investor/taxpayer is allowed to exchange one property for multiple.
In this article, we are going to discuss the “three property rule” as it relates to 1031 Exchanges. We will describe what it is, how it works, and why it may be beneficial for some investors under the right circumstances. By the end, investors will have the information needed to determine if a three property exchange is a good fit for their needs,
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What is a 1031 Exchange?
Let’s start by first defining what a 1031 Exchange is.
A 1031 Exchange is a type of commercial real estate transaction that allows individual investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sales proceeds into a new property that is “like kind” to the one that was sold. Here’s how it works.
First, an investor sells their property – this is known as the “relinquished property.” If they sell the property for an amount that is larger than their cost basis, they realize a “capital gain” and it is taxable.
To defer the tax bill, an investor can initiate a 1031 Exchange, which means that they have a 45 day identification period from the sale date of the relinquished property to formally identify a suitable replacement property and 180 days to close on the purchase of it.
In order to achieve full tax deferral, there are a number of rules that investors must follow and they are outlined in section 1031 of the Internal Revenue Code. As it relates to this article, there is a specific requirement related to the amount of debt and equity in both properties – which is where the three property rule comes into play.
The Three Property Rule Defined
With regard to the three property rule, the key provision in the Internal Revenue Code states that the debt and equity in the relinquished property must be equal to or greater than the debt and equity in the replacement property. So, for example, if a property was sold for $1,000,000 with a $500,000 loan, the new property must have a minimum of a $500,000 loan and $500,000 in equity. The three property rule is an exception to this requirement.
The three property rules states that an investor can identify up to three replacement properties, regardless of fair market value, as long as they acquire at least one of them within the 180 day period.
Why Would An Investor Do This?
There are two potential reasons why an investor would want to invoke the three-property rule in a 1031 Exchange.
The first is that they want to avoid the debt/equity requirement, which can be cumbersome when trying to find a property that is a good fit in a relatively short period of time.
The second is that an investor may actually want to acquire more than one property in order to diversify their investment portfolio. Remember, they have to acquire at least one of the identified properties, but there is no prohibition on acquiring more than one. For example, an investor could sell an office building and exchange into a multifamily property and a small retail center.
Choosing More Than Three Properties
If an investor wishes to diversify their portfolio even further, there are other rules that allow them to close on more than three properties.
Most notably, the 200% rule states that investors can identify as many potential properties as they want in the exchange transaction, as long as their total value does not exceed 200% of the value of the relinquished property.
So, while an investor could definitely diversify their portfolio under the three property rule (by legal description), the 200% may be a better way to diversify it even further.
Using a Qualified Intermediary
A 1031 Exchange can be a complicated transaction because there are a lot of rules to follow and a relatively short time frame to complete it. For this reason, it is always a best practice to use a Qualified Intermediary, sometimes called an exchange accommodator, to help facilitate the exchange.
Qualified Intermediaries are experts in the Internal Revenue Service rules that govern a 1031 Exchange and their job is to work with taxpayers/property owners to ensure that they follow all of the exchange rules. In some cases, they may even take title to the property and hold it during the exchange period or hold the exchange proceeds in escrow until it is complete.
A Qualified Intermediary does not work for free, they charge a fee for their services. However, their price may prove to be well worth it because the consequences of violating a 1031 Exchange rule could mean that the transaction becomes taxable – which could be far more expensive.
Summary of the 1031 Exchange 3 Property Rule
A 1031 Exchange is a type of commercial real estate transaction, so named for the IRC section that permits it, 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 a “like-kind property.”
The name, 1031 Exchange, implies a one for one property swap and this is exactly what happens in many cases. However, there are other cases where a property owner may want to do a one to many exchange.
The Three Property Rule states that investors can identify up to three potential replacement properties, regardless of aggregate value, as long as they close on the purchase of at least one of them.
An investor may want to invoke the three property rule to either diversify their portfolio or bypass some of the more restrictive elements of 1031 Exchange rules.
In order to ensure a transaction stays in compliance. It is always a good idea to partner with a Qualified Intermediary whose job it is to make sure all rules are followed because the consequences of violating one can be expensive.
Interested In Learning More?
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If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
