If you’re a real estate investor considering a 1031 exchange, you might be wondering what rules and requirements you should know when identifying a replacement property. As a firm that specializes in these like-kind transactions, this is one area in which we field a lot of questions.
After you sell your relinquished property, you are required to make a formal identification of the replacement property or properties you intend to acquire within 45 days of transferring your relinquished property. This is a written document that clearly lists the replacement property’s legal name and address. It’s signed by you and sent to another qualified involved person in the exchange, such as the qualified intermediary (QI) or exchange accommodator.
You aren’t obligated to acquire everything you identify on this document, but your identification must follow one of these rules:
- The three-property rule
- The 200% rule
- The 95% rule
The three-property rule and the 200% rules are the most commonly used in 1031 exchanges, while the 95% rule is used rarely. These rules aren’t too difficult to follow, but they can become a bit tricky when they are applied in the real world.
1031 Exchange Replacement Property Rules: The Three-Property Rule
Under the three-property rule, you may identify up to three pieces of real property that have an unlimited aggregate fair market value.
In other words, as long as you only identify three properties, the total fair market value of all of these properties has no impact on your exchange. This is probably the most common rule followed by taxpayers doing an exchange because it is so simple. You don’t need to worry about the values of whatever properties you identify, and you may acquire one, two, or all of those identified properties.
1031 Exchange Replacement Property Rules: The 200% Rule
The second rule is referred to as the 200% rule, and this rule allows you to name an unlimited number of properties so long as the combined value of all identified properties doesn’t exceed 200% of your relinquished property’s value.
Here’s a simple example. Suppose you’re going to sell a relinquished property with a value of $500,000. In this scenario, under the 200% rule, you could identify five replacement properties with values of $200,000 per property because the total combined fair market value of all of those replacement properties would be $1 million, and this doesn’t exceed 200%.
1031 Exchange Replacement Property Rules: The 95% Rule
The last rule, which is used least often, is the 95% rule. Like the 200% rule, the 95% rule allows you to identify as many potential replacement properties as you like, but unlike the 200% rule, this rule also allows the value of those identified properties to exceed 200%. So the 95% rule allows for an infinite number of properties of infinite combined fair market value.
The big caveat, however, is that under the 95% rule, you must acquire and close on at least 95% of the combined fair market value of all the properties you identified. This is why this rule is used least often—in practice, you have an obligation to acquire almost everything you identify, otherwise, you will have a failed exchange.
Other 1031 Exchange Identification Rules
When it comes time to identify your replacement property (or properties), there are a couple of additional rules or requirements to know.
One is the incidental property rule. In many commercial real estate transactions, there is some incidental property that is passed along to the buyer, such as laundry machines or furniture, for example. As long as that property encompasses less than 15% of the total property value, it does not need to be identified separately on your identification form.
Remember, however, that this rule applies only to identification. It is possible you could be required to pay tax on incidental personal property that is not like-kind to the relinquished property.
Work with an Expert for Your 1031 Exchange
As mentioned above, these rules aren’t too tough to understand in the abstract, but they can be a bit difficult in practice. That’s why it’s helpful to partner with an expert. CWS Capital Partners has years of experience handling the myriad issues involved with 1031 exchanges, and we can help ensure your transaction goes smoothly. Contact us today with questions or to get started with your exchange.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
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