The first important task to complete once a 1031 Exchange has begun is to identify at least one replacement property within 45 days of the date the relinquished property has closed. Understanding how to identify those properties – and how many – can be critical to a successful exchange.
1031 Exchange regulations allow taxpayers to defer capital gains taxes on the sale of business or investment real estate if the proceeds are used to acquire a like-kind property within 180 days. While that may sound simple, there are some very specific requirements that must be met during those 180 days.
An important rule to understand is that the exchanger must identify any potential replacement property(ies) within 45 days of the date that the relinquished property closes. Knowing the ins and outs of this 45-day identification rule can help you get the most out of your 1031 exchange.
The 45-day identification rule
According to Section 1031 of the US Tax Code and its regulations, the rules regarding identifying replacement properties include the following:
- The identification must be
- made in writing,
- signed by the exchanger, and
- delivered to the qualified intermediary, or other exchange party by midnight of the day that is 45 days after the date the relinquished property is transferred, regardless of weekends or holidays.
- The property must be identified in a way that is clear and unambiguous.
- Any property acquired during the 45-day identification period will be deemed identified and will count toward the total number of properties ultimately identified in the 45-day period.
- If more than 3 properties shall be identified, there will be additional restrictions on the identification. [More on this below.]
What this means is that if you’re participating in a Forward Exchange, you have 45 calendar days from the date your relinquished property is sold to identify any property that you believe may be suitable as your next business or investment property. If the exchange involves more than one relinquished property, those 45 days are counted from the date the first relinquished property closes.
But what happens if your identified property falls through due to unforeseen circumstances? What if you have several options and won’t be able to decide which one to acquire within 45 days? What if you want to spread your proceeds over more than one property? Is there any flexibility?
The answer is yes, but the number of properties you can identify, how they must be identified, and how many of them must ultimately be acquired are subject to a series of identification rules that must be taken into consideration. As part of your preparation for completing a 1031 exchange, here are the basic rules for identifying multiple properties before the 45-day deadline:
The three-property rule
The three-property rule states that you can identify up to three replacement properties, regardless of their individual or aggregate fair market value. You do not need to acquire all three; you can acquire any number of them, so long as each replacement property you acquire is among the identified properties. If you don’t acquire any of your identified properties, you won’t qualify under Section 1031.
In other words, you’re allowed to have backups. You can identify as many as three potential replacement properties with the intention of acquiring one, two, or all three of them. Should your first choice fall through between Day 45 and Day 180, you can acquire either of your other two identified properties, and your exchange will be fine.
At JTC’s recent webinar on tax-advantaged investing, Tommy Thompson, Southeast Vice President for Fortitude Investment Group, LLC, had strong words regarding whether or not it is wise to identify three properties even when you’re already certain which one is going to be your replacement property:
“Use those slots,” he said. “Have backups in place.” You never know what might happen, and by the time your sure thing falls through, it’ll be too late, so it’s best to prepare for the worst.
Identifying multiple properties is also useful when you wish to use your exchange proceeds to purchase more than one property. If you were only allowed to select one replacement property, you’d need to find something worth equal to or greater than the fair market value of your relinquished property in order to defer all of your taxes. But with the three-property rule, you can identify multiple properties and exchange into one, two, or all three of them if desired.
A word of caution: if you identify more than one property and you only intend to purchase one of them, semantics count. In the event you do not use all of the proceeds from the relinquished property, you wouldn’t be entitled to the balance of exchange funds until after the 180-day exchange period passes, unless you were careful to use the key word “or” in your list of identified properties. For example: “Property A, or Property B, or Property C” would make it clear that once you acquire one of them, your exchange is over. If you use the word “and” or simply make a list, the regulations state that your exchange will not be complete until you have acquired all replacement properties to which you are entitled – and you would still be entitled to those additional properties, meaning your excess funds would remain in the exchange account until after Day 180.
Is it possible to identify more than three properties?
Three is the limit before additional restrictions come into play.
In an attempt to force exchangers to make a solid effort at identifying potential replacement properties during the 45–day identification period, the IRS sought to keep the number of properties to a reasonable amount and prevent taxpayers from identifying all properties on the market, or an entire geographical area. Thus was born the 200% rule.
The 200% rule
The 200% rule states that any number of properties can be identified, provided their aggregate fair market value does not exceed 200% of the value of the relinquished property(ies) subject to the exchange.
To understand this rule better, here’s an example: if you sold a home with a value of $500,000 and identified four properties, each valued at $500,000, the aggregate fair market value would be $2 million, or 400% of the value of the relinquished property. That’s too much, and so the identification would not be valid.
But let’s try a different example: say you sold a large apartment building in an urban area valued at $2 million, and wish to diversify your portfolio into multiple smaller properties. To achieve the maximum flexibility in identifying these diversified investments, the 200% rule allows you to identify as many properties as you want so long as the aggregate fair market value of those properties stays below $4 million (200% of the $2 million value of the relinquished property). And better yet, you can ultimately acquire as many of those identified properties as you like.
But what happens if you find yourself wanting to identify more than 3 properties and the aggregate value exceeds 200% of the fair market value of the relinquished property? Though quite rare in practice, the 95% rule allows for the exchanger to identify as many properties as they wish, and at any fair market value, but this triggers a new restriction.
The 95% rule
The 95% rule states that it is possible to identify any number of properties, with an unlimited aggregate fair market value, provided that the exchanger acquires at least 95% of the aggregate fair market value of all properties identified.
This rule is really more of an exception than a rule because it is quite difficult to accomplish. That said, there is one scenario where this will often work:
You have identified a portfolio of properties being sold by one person or group of people. In this scenario, you are likely to buy the entire portfolio or none at all. If successful, your exchange proceeds would be applied to the entire portfolio and you would end up acquiring 100% of the properties identified.
Ultimately, the identification of replacement properties can make or break your ability to defer taxes using a 1031 exchange. Not understanding the nuances can leave you with an unexpected tax bill, which is why it’s important to talk with your tax adviser prior to initiating your exchange so you fully understand all rules and can follow them properly to maximize the tax benefits of 1031.
What happens if I can’t find a suitable replacement property by Day 45?
Thompson said he often hears from exchangers looking for advice after they’ve failed to identify a replacement property in time, but that at that point, there’s little that can be done.
“These are IRS rules. There’s no going back,” he said. “That preparation phase is the most important part.”
If you fail to identify suitable replacement properties by the deadline, you’ll lose your chance to complete your 1031 exchange. That’s why it’s critical to work with the right people from the very beginning and be smart about your choice of replacement properties. Start looking even before your relinquished property is sold so you don’t lose valuable time searching for the ideal replacement properties.
“A DST can be a great solution as a backup,” said Thompson. Delaware Statutory Trusts are a real estate holding structure which allows multiple purchasers to buy an interest in a property that is often larger than they could purchase on their own, and doesn’t require them to be an active manager. Better yet, this structure qualifies as like-kind replacement property in a 1031 exchange, and the heavy lifting to negotiate the purchase and sale agreement is born by the DST sponsor, which is why many exchangers include a DST in their list of potential properties.
If you miss the 45-day deadline, all is not lost. You may not be able to defer taxes through a 1031 exchange, but there are other tax-advantaged mechanisms tucked in the Internal Revenue Code. For example, Opportunity Zone investments can be used to defer capital gains taxes not only from the sale of real property, but also from sales of stocks or businesses as well. If 1031 is no longer an option, it’s worth learning about OZ as part of a smart tax strategy.
The best choice you can make for a successful exchange
One rule regarding deferred 1031 exchanges that absolutely must be followed is that you need to work with a Qualified Intermediary. The QI performs several important jobs, not the least of which is holding proceeds from the relinquished property until the replacement property is acquired. At our webinar, we asked attendees what criteria matters most to them when selecting a QI.
The most common answer? With an overwhelming 79% of responses, the vast majority of those in attendance said “Expertise.”
“One of the most important things to me is communication, and JTC Americas as a Qualified Intermediary does that really well,” said Thompson. “Having a QI that you can get a hold of at some tough times is so important.”
Michael Simpson, Founder & Senior Instructor at The NCREA, provided a strong recommendation with a personal story about using 1031 to exchange into a Delaware Statutory Trust with the help of Thompson and JTC’s Justin Amos. You can watch the full webinar here to learn more about tax-advantaged strategies in real estate.
If you want things done right, you need to work with an experienced partner, and JTC’s team has decades of experience, with tens of thousands of successful transactions, as well as specific expertise in reverse exchanges and DSTs. By combining our elite expertise with award-winning technology, JTC offers its 1031 exchange clients the ultimate in security, transparency, and compliance.
Learn more about JTC’s Qualified Intermediary services by downloading our 1031 Exchange Solution Sheet!