Real estate investors have long turned to 1031 exchanges to defer capital gains taxes following the disposition of highly appreciated real property assets.
While many exchanges involve multi-million-dollar properties owned by institutional and accredited investors, the majority of 1031 exchanges are undertaken and completed by Main Street real estate investors. From 2010 through 2020, the average sale price of assets involved in 1031 exchanges was $575,000.1 Like-kind exchanges accounted for approximately 10 to 20 percent of all real estate transactions in that time frame.
Although billions of dollars worth of commercial real estate has traded hands through the 1031 exchange process, some investors have wondered if there is a limit on property values involved in like-kind exchanges. The answer to that question lies in 1031 property identification rules.
Let’s take a look.
1031 Property Identification Rules
Real estate investors who undertake 1031 exchanges have three ways (and a mere 45 days) in which they can identify prospective replacement properties to complete their exchanges:
- Three-property rule
- 200 percent rule
- 95 percent rule
We’ll dive into each property identification rule to paint a clearer picture of the 1031 exchange valuation process.
This is perhaps the simplest replacement property identification method, which is why it’s the identification rule most often utilized by exchangors. You have 45 days to identify up to three replacement properties regardless of their fair market value. You can potentially exchange from a $1 million adjusted cost basis in a triplex to a small $5 million apartment complex so long as any debt from the relinquished property is equal to the debt on the replacement property.
This identification rule is the best way to trade up in value on a one-for-one property exchange, although exchangors can exchange into two or even all three properties they’ve formally identified.
If you identify more than three prospective replacement properties and want to exchange into multiple assets, the 200 percent rule comes into play.
200 Percent Identification Rule
Exchangors can identify more than three replacement properties provided their combined fair market value doesn’t exceed 200 percent of the fair market value of the relinquished asset. Essentially, any properties you identify can’t be double the value of your original property.
This identification strategy could be beneficial for investors who have highly appreciated real estate assets and are struggling to find one-for-one property swaps in competitive real estate markets with limited sale/exchange inventory. If your property has a fair market value of $15 million, you could identify any number of replacement assets provided their aggregate value doesn’t exceed $30 million. This identification strategy opens up a tremendous range of potential replacement asset classes and property types and could lead to increased portfolio diversification.
To harken back to the original question of maximum exchange values, though, the taxpayer is limited in this identification rule by the fair market value of his or her relinquished property since replacement property values cannot break the 200 percent threshold by even a fraction of a percent.
95 Percent Rule
The final identification rule in 1031 exchanges is also the most seldom-used identification strategy.
Exchangors who use the 95 percent rule can identify an unlimited number of replacement assets provided they are able to close on 95 percent of the aggregate value of the identified properties. Here’s an example:
- Your relinquished asset sells for $10 million, and under the 95-percent identification rule you formally identify five replacement properties with a combined fair market value of $25 million. You’ll have to close on at least $23,750,000 of that number.
The reason why the 95 percent rule is the least-used identification strategy is because it can get complicated for investors to wrap up multiple closings within the 180-day window of selling their original properties.
Putting it all Together
The maximum value allowed in a 1031 exchange really depends on the fair market value of your relinquished asset, the identification strategy you choose, and your financial wherewithal to acquire and close on prospective replacement assets.
A main goal of 1031 exchanges for many investors (besides deferring capital gains taxes) is to trade up in asset value. You could swap a $5 million property for a $25 million asset provided you were able to secure financing and handle the additional leverage. It’s a good idea to consult with qualified professionals before undertaking a 1031 exchange to determine your exchange strategy.
1 The Tax and Economic Impacts of Section 1031 Like-Kind Exchanges in Real Estate, Real Estate Research Consortium, https://warrington.ufl.edu/due-diligence/wp-content/uploads/sites/179/2021/04/the-tax-and-economic-impacts-of-section-1031-like-kind-exchanges-in-real-estate.pdf
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Hypothetical examples shown are for illustrative purposes only.