Can You Exchange One 1031 Property for Two?

Selling an investment property can bring about many difficult decisions. 

Owners of highly appreciated assets will likely generate a sizable capital gains tax liability when divesting those assets – unless they complete a 1031 exchange. Real estate investors have used exchanges for decades to defer taxes on realized gains taxes from the sale of investment properties. 

Finding a suitable replacement property that satisfies the financial requirements to complete a 1031 exchange and fully defer capital gains taxes can be tough, especially in markets with strong investor demand. If there’s a paucity of potential investment properties in your region, don’t get hung up on finding that one perfect property. Broaden your search by selecting multiple real estate assets to complete your exchange. 

Let’s take a closer look at what that means. 

Multi-property Exchanges: What You Need to Know 

In a straight one-for-one 1031 exchange, investors swap one investment property for another. In order to avoid creating taxable boot, investors typically seek to trade across or up in property value and mortgage debt. 

Identifying a replacement property that aligns in value and mortgage debt isn’t always easy or possible, especially when real estate markets are frothy and potential investment properties are quickly snapped up in off-market deals. You don’t have to find that perfect match, though. You can select up to three properties to complete your 1031 exchange, and in many instances, you may find it more advantageous to swap one investment property for multiple assets. 

There are strict rules to how it all shakes out. Let’s rehash some important 1031 exchange basics, which will give you an idea of how the process of selecting multiple properties to complete your exchange works. 

• 45-day formal identification period. Upon close of sale on your relinquished asset, you have 45 days to formally identify up to three like-kind properties. 
• 180 days to close. This timeline also starts upon the close of the sale on your original property. 
• Use of a qualified intermediary. At no time during the exchange process can you touch any of the sale proceeds. Sale and acquisition transactions must be conducted through a qualified intermediary, who will hold funds from your relinquished property in an escrow account until they are needed to complete the exchange. 

There are, of course, a host of additional guidelines and rules to which you must adhere to successfully complete a 1031 exchange. Let’s examine the three rules that will guide your investment options for exchanging into multiple properties. 

Multi-Property 1031 Exchange Rules 

Internal Revenue Code Section 1031 lays out the guidelines for multi-property exchanges.  

1. Three Property Rule. You can formally identify up to three replacement assets to complete your exchange. You don’t have to identify three potential replacement properties, but identifying multiple assets sure could save your bacon if you have any problems closing on your preferred asset during the 180-day timeline. 
2. The 200-percent Rule. This rule states that you can identify more than three like-kind replacement properties provided their combined value isn’t greater than 200 percent of the sale price of your relinquished asset. You can identify five, six, or even seven properties provided their aggregate values don’t exceed 200 percent of what you got for your original property. 
3. The 95 Percent Rule. This rule states that you can identify more than three potential replacement properties with an aggregate value greater than that 200 percent maximum outlined in Rule 2 so long as you acquire at least 95 percent of the total fair market value of those identified assets. 

Putting it all Together 

There’s a good reason why the majority of 1031 exchanges are simple one-for-one simultaneous swaps: it’s a complicated process. 

Attempting to close on multiple properties adds extra spice to the stew and may spoil the flavor. Put another way, 1031 exchanges are fraught with potential missteps – missed deadlines, your financing falls through, etc. – that could result in an invalidated exchange. There can be many potential benefits, such as increased portfolio diversification, decreased concentration risk, and the opportunity to realize greater cash flow and asset appreciation from owning multiple real property assets. However, a multi-asset exchange can greatly increase your execution risk. 

Completing a multi-property exchange requires careful planning and precise execution. Investors should consider engaging legal, taxation and other professionals with experience in 1031 exchanges to help them navigate the onerous exchange process, especially when multiple properties are involved.