The idea behind 26 U.S. Code § 1031 – “Exchange of Real Property held for Productive Use or Investment” – is that the investor can trade relinquished real estate for properly identified as replacement real estate to benefit from a capital gains tax deferral.
But many factors are involved in finding and identifying a replacement property for a 1031 exchange. Failure to meet these requirements could void the exchange. This, in turn, leaves the investor with an unexpected tax bill.
The first “must do” when it comes to identifying that replacement property is to do so within 45 days of selling the relinquished property. These are calendar days, not business days. As such, if midnight on the 45th day falls on a weekend or holiday, it is still enforced.
The investor can identify a replacement property or properties under one of three rules:
Three-Property Rule. The investor can identify up to three properties for exchange purposes, as long as the property/properties are equal to or greater than the sales price of the relinquished property.
200% Rule. If the investor identifies more than three potential replacement properties, they need to add up the total fair market values of all these properties. The total must not exceed 200% of the relinquished property’s sales price.
95% Rule. This kicks in when the investor identifies more than three properties, and the properties exceed the 200% rule. The 95% rule means an investor can identify an unlimited number of potential replacement properties, as long as those properties equal 95% of the aggregate identified value within the exchange period.
The investor must also identify the replacement property formally with one of the following methods:
The written form is signed by the investor and delivered to the Qualified Intermediary (QI). Information on this form includes a description of the replacement property/properties. This information includes the replacement property’s legal definition, distinguishable name and street address.
Under 1031 rules, the investor has 180 days following the close of the relinquished property to close on that replacement property. But if the investor purchases the replacement property within the 45-day identification period, no written identification is required. However, if the investor plans to buy additional properties under the exchange rules and hasn’t yet closed on those assets, written identification must be provided.
It’s been mentioned many, many times – a successful 1031 exchange depends on strict adherence to IRS-mandated rules. Failure to abide by even just one of these rules can make that exchange ineligible. As such, before embarking on a 1031 exchange, it’s a good idea to work with a professional who understands the ins and outs of the process.