The 1031 exchange, named after the section of the Internal Revenue Code (IRC) that describes it, is infamously complex, with a multitude of rules that must all be strictly observed. Practice shows that investors are quite willing to submit to these restrictions in return for the benefits the exchange offers.
By participating in a 1031 exchange, an exchanger can relinquish a real estate asset and replace it with another of equal or greater value while deferring capital gains taxes and depreciation recapture. One of the complexities of the procedure is identifying one or more 1031 exchange replacement properties. While the IRC provides an exhaustive discussion of this topic, many exchangers will it find helpful to go over this material in a more accessible format.
Steps to Identifying a 1031 Exchange Replacement Property
The first thing that is likely to come to the exchanger’s attention is that there are two essential deadlines for a 1031 exchange. The first is the 45-day identification period, starting on the day the property being relinquished is sold, during which the exchanger must identify replacement property or properties “substantially the same” as what they will buy before the end of the 180-day exchange period.
Any property purchased within the 45-day selection period can be used in the exchange. It is worth noting that the exchanger can have a replacement property in mind, or begin looking for that property, before the exchange is even initiated. If no property is purchased by the 45th day, a few rules go into effect, however. By midnight of the 45th day, the exchanger must inform the qualified intermediary and other interested parties—the escrow company, for example—of the final choice of potential replacement properties. Before the end of the 45th day, exchangers can make identifications and then change their minds, but after the 45th day, only properties identified at that time can be used in the exchange.
Furthermore, property to be purchased after the 45th day has to be identified in accordance with one of three rules:
- The three-property rule. The exchanger can identify up to three properties and buy one, two, or all three of them, regardless of their total value. If the exchanger chooses to identify more than three properties, they have two choices:
- The 200-percent rule. The exchanger can identify any number of properties as long as their total value does not exceed 200 percent of the value of the property relinquished.
- The 95-percent rule. The exchanger can identify any number of properties as long as the exchanger’s purchase amounts to 95 percent of the value of those properties.
If the exchanger is buying the replacement property with someone else, ownership has to be structured as tenants in common, rather than a partnership. The percentage of the property that is going to be used as the replacement in the exchange has to be specified at the time of identification.
Purchasing the Property Identified as an Exchange Property
The exchanger need not have any of the properties identified under contract at the end of the 45 days, but he or she cannot use anything other than the properties identified in the exchange. The replacement property or properties must be identified exactly by address, including unit number, if applicable, or unambiguously by name. The exchanger is provided a small amount of leeway in the purchases, seemingly in acknowledgment of the vagaries of doing business. The 95-percent rule is an example of this. An exchanger must have a very clear idea of the intended replacement purchases to identify them so closely that the final purchase has 95-percent precision, but there is a 5 percent margin of error provided, just in case.
Another example of this flexibility is disregarding incidental property. “Property that is incidental to a larger item of property,” as the IRC describes it, and worth up to 15 percent of the total value, can be disregarded in calculations. The IRC includes an example of washing machines in an apartment building. Determining that a property is “substantially the same” as it was when identified may be a somewhat subtler process than spotting what is incidental. There are more examples provided in the IRC, but interpretation may be more difficult. It is clear that the concept allows for only minor differences between what was identified and what was purchased.
The 1031 exchange can be tremendously beneficial for investors. But, as can be seen in this look at just a small portion of the procedure, the exchange must be made within strict bounds. This makes it especially important to have competent professional advice.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and multifamily real estate valuation to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country and employ a team of experts who can help you hone your investment strategy.
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