On paper, relying on the Internal Revenue Code (IRC) section 1031 to defer capital gain taxes on a real estate sale seems straightforward. You target the replacement property within 45 days, then close on that property within 180 days. Your Qualified Intermediary handles the exchange, resulting in a new property and a sweet tax deferral.
But in reality, the 1031 Exchange is an exacting, precise exercise, which, more often than not, can lead to frustration and disallowable actions from the Internal Revenue Services (IRS). The good news is that the IRS is specific when it comes to different rules for exchanges. The three rules are:
- Three Property
Let’s dive into these.
Three-Property Rule is the most common when it comes to the 1031 exchange. It allows you to target up to three properties within the 45-day identification regardless of value. Most investors don’t exchange into all three, of course. More often than not, exchange involves one of the three, with the other two as backups.
Bringing this into the real world, let’s say you own a fourplex valued at $100,000, and you’re interested in exchanging the asset into other property. Under the three-property rule, you could identify one rental cottage valued at $105,000. You could also identify three rental cottages valued at $105,000, $110,000 and $125,000, respectively. You wouldn’t be obligated to exchange into all three – but you could identify one, with the other two as backups.
Advantage: You can identify one, two or three properties, and acquire any, or all of them, regardless of fair market value. They would need to be at least the same value as your relinquished property.
Disadvantage: You can ONLY identify one, two or three properties. If you target anything higher, you’ll move on to the 200% rule.
The 200% Rule lets you identify, and exchange into, as many properties as you want – so long as the aggregate fair market value of those properties doesn’t exceed two times the fair market value of your relinquished property. Under the 200% rule, you could identify four, five or even 50 replacement cottage properties for that $100,000 fourplex you’re relinquishing, and could exchange into all of them – as long as their value fits under that $200,000 cap. But if the fair market value of your targeted replacement properties climbs to $200,010, the IRS could disallow it.
Advantage: You can identify as many replacement properties as you want, as long as the value fits under that two-times-the-fair-market-value-of-your-relinquished-property category.
Disadvantage: The operative words here are “fair market value,” which can change from property identification to closing. Any increase in fair market value could doom your tax deferral hopes. Or, you could use the 95% rule.
The 95% Rule is the most flexible – and the trickiest – of the three rules. Under these guidelines, you could identify more than three properties for an exchange. Nor are you restricted to a 200% cap. Upon closing, however, you would need to exchange into replacement properties with an aggregate fair market value of at least 95% of all the identified properties.
Let’s go back to your $100,000 fourplex. Under the 95% rule, you could identify 10 rental cottages (or more or less than 10 if you desire), with a fair market value of $350,000. At closing, the aggregate fair market value of those cottages must be at least 95% of $350,000 – or $332,500. If the combined value of that portfolio falls to $332,499 or lower, you would need to find another property to get back to that 95% and tax deferral.
Advantage: You can identify as many replacement properties as you want, at whatever value.
Disadvantage: Again, “fair market value” needs to be considered. There can be up to a six-month lag between property identification and closing. If the value of your replacement property/properties falls below that 95% threshold (or if one of the properties you’ve targeted is sold to someone else), you could be stuck with the capital gains tax you’re attempting to defer.
1031 Exchanges are ideal tools for tax deferrals but can also be tricky to execute. Realized Holdings is ready to help guide you through the exchange maze, allowing you to execute your 1031 strategy. For more information, call 877.797.1031, or log on to www.realized1031.com.For more information regarding these three identification strategies, refer to Title 26 of the Code of Federal Regulations § 1.1031(k)-1 - Treatment of deferred exchanges.