A 1031 Exchange – sometimes called a deferred exchange or delayed exchange – is a type of real estate transaction that allows commercial real investors to defer capital gains taxes on the profitable sale of an investment property. But, in order to take advantage of this potentially tax saving opportunity, there are a number of rules that investors must comply with, particularly around the identification of the properties involved in the exchange.
In this article, we are going to discuss the property identification rules in a 1031 Exchange. We will describe what they are, why they matter, and what the consequences are for violating them. By the end, readers will have a more thorough understanding of the 1031 Exchange identification process and will be able to incorporate this information into their 1031 Exchange decision making process.
At First National Realty Partners, we specialize in the acquisition and management of grocery store anchored retail centers. During our normal course of business, we frequently help investors place 1031 Exchange funds. If you are an Accredited Investor and would like to learn more about how we can help facilitate a 1031 Exchange, click here.
Understanding 1031 Exchange Property Terminology
In order to understand the property identification rules in a 1031 Exchange, it is first necessary to understand the terminology used to refer to the properties involved in a 1031 Exchange. There are two of them.
First, the property that is sold is referred to as the “Relinquished Property.” The gain on this sale is what triggers a taxable event and serves as the inspiration for the 1031 Exchange.
The proceeds from the sale of the Relinquished Property must be reinvested into another property that is considered to be “like kind.” This property to be purchased is referred to as the “Replacement Property.”
With this terminology clarified, it is easier to understand the identification rules.
Identification and Receipt Rules
With regard to the purchase of the replacement property in the 1031 Exchange, there are five key rules that investors must keep in mind.
The 45-Day Identification Rule
When the sale of the Relinquished Property has been completed, investors have a 45-day identification period (calendar days) during which they are required to identify, in writing, their planned replacement property or properties. This time frame is particularly important to remember because it goes by quickly and competition for the best replacement properties can be intense. In a worst case scenario, investors may be left scrambling at the last moment to find and identify potential replacement properties. To avoid this, investors should do whatever they can to get a headstart on the replacement property identification process.
The 180 Day Exchange Period
From the date of the sale of the Relinquished Property, investors have a 45 day period to identify the Replacement Property and 180 days to complete the purchase of it.
Said differently, on a timeline, the sale of the Relinquished property is day zero, and the replacement property must be identified by the 45th day. Then, investors then have an additional 135 days to complete the purchase of the identified properties.
The 3-Property Rule
Whereas the first two rules deal with the timeframe required to identify and close on the properties, this rule has to do with the number of properties that can be identified.
In many cases, a 1031 Exchange is one-to-one, meaning that investors sell one property and buy one property. But, this is not always the case. The three property rule states that investors can identify up to three potential replacement properties, regardless of fair market value, as long as they close on one of them within the required 180 day time frame.
If the investor so chooses, they could purchase one of the three properties. Or, they could purchase all three in an effort to diversify their property portfolio.
The 200% Rule
If an investor/taxpayer feels limited by the three property rule, they might be able to operate under the 200% rule, which allows them to identify as many Replacement Properties as they want as long as the aggregate value does not exceed 200% of the value of the Relinquished Property.
Again, the primary reason that an investor would want to complete a one to many exchange is that they want to diversify their portfolio.
The 95% Rule
The 95% rule states that investors can identify more than three replacement properties that have a total value of more than 200% of the value of the Relinquished Property, as long as they close on at least 95% of the value of the identified replacement properties.
This rule is not used as commonly as the others because it requires the investor to close on everything they identify, which can be expensive and complex.
The Incidental Property Rule
While a 1031 Exchange primarily involves real property, there are occasions where other items such as personal property, furniture, or other effects come with the Replacement Property.
When this is the case, the incidental rule states that personal property received that is incidental to the real property is exempt and does not qualify as an early receipt of 1031 Exchange proceeds. It is important to note that the incidental property received does not count as part of the 1031 Exchange and does not qualify for tax deferral.
Identification Requirements For The Replacement Property
There is a specific process that must be followed to identify the Replacement Property in a 1031 Exchange.
First, it is a best practice to work with an individual or firm known as a “Qualified Intermediary” – sometimes called a QI or Accommodator. Their job is to help guide investors through the Exchange process, including the identification of the Replacement Property.
Under established IRS rules, the Replacement Property must be “unambiguously” described in a written document or agreement. Typically, the property is identified by its street address or legal description or distinguishable name – such as the name of an apartment building.
If the number of replacement properties exceeds one, then these elements should be included in the description of each Replacement Property to be included in the exchange transaction.
1031 Exchange Identification & Real Estate Syndications
As this article highlights, there are a lot of rules that investors must abide by when completing a 1031 Exchange. For those unfamiliar, it can be a difficult maze to navigate and the consequences of getting it wrong can be significant. For this reason, many investors find that it may be beneficial to work for a professional firm, like a private equity firm, to complete a 1031 Exchange.
In this structure, an investor could purchase a fractional share of an institutional grade commercial asset through a structure known as a “syndication.” There are two notable benefits to this approach for individual investors. The first is speed – it can be much faster and much less stressful to purchase a fractional share of a property rather than trying to track down an individual property on their own. The second benefit is expertise – the syndication leader can help guide investors through the process and they often manage the property after the deal closes, making it a truly passive investment.
Structurally, this type of arrangement is typically accomplished through a “tenant-in-common” ownership structure or through something known as a Delaware Statutory Trust – DST for short.
Finally, a note about suitability. 1031 Exchanges are not suitable for all investors. Each individual has their own set of unique financial circumstances, return requirements, and risk tolerance. It is always a best practice to work with a tax advisor, financial planner, or tax attorney to ensure that the transaction is the right fit for the circumstances.
Summary of 1031 Exchange Identification Rules
A 1031 Exchange is a type of real estate transaction that allows real estate investors to defer capital gains taxes on the profitable sale of an investment property.
There are two properties involved in a 1031 Exchange. The “Relinquished Property” is the property that is sold by the investor and the “Replacement Property” is the property that is purchased by investors.
In order to complete a 1031 Exchange, there are a number of rules that investors must follow regarding the identification of the Replacement Property. They include the 45 day rule, the 180 day rule, and the three property rule.
Because a 1031 Exchange is a complicated transaction, it may be a good idea for individual investors to work with a tram of advisors including a CPA, tax attorney, and Qualified Intermediary.
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If you are an Accredited Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.