The 1031 exchange process is intricate, with the IRS setting up many rules to ensure compliance and avoid abuse of the tax deferral benefits. One such rule is the Three Property Rule which states that an investor may identify up to three like-kind properties to exchange. However, there is a way to exchange more than three properties if an investor chooses to do so. This course of action is possible through the 1031 exchange 200% rule. What does this process entail? How do you leverage it? Below, Realized 1031 has shared an article answering these questions to help you better understand how the 200% rule works. Keep reading to learn more.
The Basics of the 1031 Exchange Process
The 1031 exchange process is an investment strategy that’s mainly used for its tax deferral benefits. Named after Section 1031 of the IRS code, the like-kind exchange allows property owners to swap real estate assets for another of the same or greater value. Since no constructive receipt of funds has occurred during the exchange, there is no tax liability. You can defer the capital gains taxes so long as you continue exchanging properties for another of a similar asset class. Only when you make a constructive receipt will you have a tax liability.
The IRS has many rules in a 1031 exchange. Here are some of the most prominent ones.
- Like-kind Requirement: You can only exchange real property that is held for productive or investment purposes. This includes assets such as raw land, residential real estate, commercial real estate, and even oil and gas royalties. As such, swapping primary residences is not allowed.
- Equal or Greater Value: The acquired property must have the same or greater market value than the relinquished property. If it’s any less, the remaining amount is considered boot and is taxable.
- 180-Day Timeframe: The entire exchange process must happen within 180 days after you close the sale of your relinquished property.
- 45-Day Identification Period: Within the 180-day period, the IRS gives you 45 days to officially identify properties to acquire for the exchanged property.
Although the three-property rule has historically been the most common strategy for identifying property within 45 days, what if you want to invest in a portfolio of real estate assets and diversify your portfolio? This is where the 1031 exchange 200% rule comes in.
What Is the 1031 Exchange 200% Rule?
While the IRS has seemingly rigid rules in 1031 exchanges, there are several stipulations that help investors gain more options when choosing properties they want to acquire. The 200% rule is one such mandate, allowing investors to identify multiple assets so long as the aggregate value does not exceed 200% of the relinquished property’s market value. The default system is the three-property rule. However, some investors find this number too limiting, especially if they’ve set their eyes on four or more possible replacement properties.
Let’s say that the relinquished property has a market value of $2 million. If this is the case, then you can identify as many properties as you can so long as their total value is below or exactly $4 million. Past the 200% rule, and you will need to comply with the 95% rule. In this case, the IRS will require you to acquire at least 95% of the total value of the identified properties.
Reason Why the Like-kind Exchange 200% Rule Exists
Why is 200% the limit? This value provides flexibility for investors while still staying within the rules of the 1031 exchange. The IRS set this limit to prevent abuse and ensure that the exchange process remains manageable for investors. If the 200% limit doesn’t exist, then an investor may list excessively high-value properties that complicate IRS oversight and dilute the intent of the like-kind exchange.
Since there’s a limit to the total value of identifiable properties, an investor can still choose as many as they want, depending on their needs. With the clearer framework, the 200% rule helps simplify compliance while enabling strategic investment on the investor’s end.
Calculating the 200% Limit
It’s relatively straightforward to calculate the 1031 exchange 200% rule. Here’s what you need to do to ensure precision and compliance.
- Determine the fair market value of the relinquished property: The fair market value or FMV will be established during the sales process, so you should have this amount even before the identification period starts. Let’s say that you’re exchanging an apartment building worth $5 million.
- 200% Limit: To find the 200% limit, simply multiply the FMV by two. In our example, $5 million x 2 is $10 million. This will be the identification limit.
- Calculate the combined values of the identified properties: Let’s say that you were able to find four properties with the following values.
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- Property A: $3 million
- Property B: $2 million
- Property C: $1.5 million
- Property D: $3.5 million
Combined, these four properties have an aggregate value of $10 million — within the 200% limit. If one has a higher value, then you will have to adhere to the 95% rule to maintain the tax-deferred status.
When To Use the 200% Rule
There are a few scenarios where the 200% rule is the most ideal strategy when identifying properties.
Mitigating Execution Risk
Oftentimes during the identification process, investors are uncertain on whether they will be able to close on all or some of the properties that have chosen to identify within 180 days. To give investors maximum flexibility and backup options for their exchange, the 200% rule can be used to mitigate execution risk and ensure that other options are available to invest into. One example of this is using Delaware Statutory Trust investments as a backup option in the scenario that the purchase of a direct property falls through.
Desire for Diversification
Instead of putting all your proceeds into a single asset, you may want to put into several ones that have lower value than the relinquished property. Some investors want this benefit to diversify their portfolios, especially if they see opportunities in certain markets. This approach also spreads risk since you won’t rely on the performance of a single asset to maintain a steady cash flow. Additionally, investing in multiple lower-value properties can provide greater liquidity and flexibility, making it easier to adapt to market changes.
200% Rule vs. Other Identification Rules
There are three primary property identification rules in 1031 exchanges, all of which we’ve mentioned above. Here’s how the other two compare to the 200% rule.
Three-property Rule
The three-property rule allows investors to identify up to three like-kind properties so long as they meet the equal or greater value requirement. There’s no aggregate value limit in this case. If the FMV of the relinquished property is $1 million, then you can choose three $1 million properties. The aggregate of these three is $3 million, which is above the 200% limit. However, the limit becomes irrelevant since you’re following the three-property rule.
95% Rule
The 95% rule only applies if you identify multiple properties that exceed the 200% limit. The IRS will allow you to identify as many as you want, but the agency will require you to acquire 95% or greater of these properties. This strategy can potentially increase the capital you need to maintain the tax-deferred status. Plus, as you increase the number of identified properties, the more complicated the process becomes. It comes as no surprise that the 95% rule is seldom used in practice.
Choosing between the three options depends on your investment goals. If you want the most straightforward process and acquire only one property, the three-property rule is the ideal step. In contrast, those who want to invest in more assets can choose the 200% rule. In this arrangement, the IRS won’t ask you to invest in all the identified properties (unlike the 95% rule). Just as many or as few as you wish.
Wrapping Up: All You Need To Know About the 1031 Exchange 200% Rule
The like-kind exchange 200% rule allows investors to identify as many properties as they can so long as the aggregate value of these properties is within 200% of the relinquished one’s FMV. This strategy helps investors invest in more properties and avoid putting all the proceeds into a single asset.
Navigating the 200% rule can be complex, especially with how you’re identifying several properties. You’ll want to engage with 1031 exchange experts like us at Realized 1031 to ensure accuracy and full compliance with IRS regulations. To learn more about this rule and how it works, talk to one of our experts. Contact us today to schedule a consultation.
The tax planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.irs.gov/pub/irs-news/fs-08-18.pdf
https://www.investopedia.com/financial-edge/0110/10-things-to-know-about-1031-exchanges.aspx
