In order to complete a successful 1031 exchange, it is important to understand and comply with the identification requirements, as outlined by the Internal Revenue Service. The rules are not complicated, but failure to follow them may ruin your exchange. Here are the most common questions that we are asked
about the identification requirements:
WHAT ARE THE TIMING REQUIREMENTS FOR IDENTIFICATION?
The timing requirements are critical for a successful exchange; the taxpayer has 45 days from the date the relinquished (sale) property closes to identify replacement (purchase) property. The identified properties must be acquired within 180 days of the relinquished property closing or by the due date for filing the tax return for the year that the relinquished property closed, whichever is earlier.
HOW MANY PROPERTIES CAN I IDENTIFY?
The two most common identification methods are:
- Three-Property Rule: Up to three properties may be identified without regard to the fair market value, and you may acquire one, two, or all three. If you are acquiring just one property, it is always a good idea to name two additional properties as backup.
- 200% Rule: If you want to acquire more than three properties, the 200% rule may be used. It allows you to identify any number of properties as long as their combined fair market value does not exceed 200% of the fair market value of all relinquished property. This rule is useful if you are exchanging out of a higher priced property and want to diversify to less expensive properties.
WHAT HAPPENS IF I EXCEED BOTH THE THREE-PROPERTY RULE AND THE 200% RULE?
You can still have a valid exchange even if you don't comply with the Three-Property Rule or the 200% Rule if you acquire at least 95% in value of all properties identified. In addition, any properties acquired during the 45-day identification period are deemed properly identified.
CAN I CHANGE THE IDENTIFIED PROPERTIES AFTER I HAVE NAMED THEM?
If you are within the 45-day identification period, you may revoke identified properties and replace them. The revocation must be done in writing and must be sent to the same person or company to whom the original identification was delivered. It is important to note that for successful tax deferral you may only acquire the properties identified in the 45-day time frame.
DO I HAVE TO PURCHASE ALL THE PROPERTIES I IDENTIFY?
That answer can vary depending on your investment strategy. An important thing to note in an exchange is that in order to defer all taxes you must acquire replacement property equal or greater in value and equal or greater in cash equity than all relinquished properties.
DO I HAVE TO HAVE AN ACCEPTED OFFER ON THE PROPERTY BEFORE I IDENTIFY IT?
You do not have to have on offer on a property to identify it; however, it may be in your best interest to have an accepted offer on the replacement property as soon as possible within the 45 days. Identification can be made anytime within the 45 days, and typically properties are identified close to the 45th day with a contract in place and backups included, if possible.
CAN I MAKE AN OFFER ON REPLACEMENT PROPERTY BEFORE THE RELINQUISHED PROPERTY HAS CLOSED?
Yes, you absolutely may get a replacement property under contract to purchase before you have closed on the relinquished property. Having your purchase property under contract sooner rather than later gives you peace of mind and allows you to get the property you want. It may be wise to make the purchase contingent on the successful closing of the relinquished property so that you are not obligated to purchase the property if your relinquished property does not close.
WHAT ARE THE ISSUES WHEN EXCHANGING FROM MULTIPLE PROPERTIES AND CONSOLIDATING INTO ONE LARGER PROPERTY?
The issue to be aware of is that once the first relinquished property closes, your 45-day identification period begins. It is important to try to get a closing date on all the relinquished properties as close together as possible. If you are exchanging out of two properties and into one and only one relinquished property has closed by the 45th day of identification, you will have to determine whether or not to identify replacement property equal to the sale price of one property or two. Remember, as stated above, in order to defer all taxes you must acquire replacement property equal or greater in value and equity than all relinquished properties.
IT’S A SELLER’S MARKET, SO WHAT IS THE BEST STRATEGY TO MAKE SURE I GET THE PROPERTY I WANT?
The best strategy is to get your replacement property(ies) under contract as soon as possible and close within the 45 days. The second best strategy is to have the replacement property under contract within the 45 days and, hopefully, remove all contingencies. If you are using the three-property rule, you can then identify two backup properties towards the end of the 45 days that will, hopefully, be available if your first choice property does not work.
IF MY IDENTIFIED PROPERTIES DO NOT WORK OUT, CAN I BUY A PROPERTY I DID NOT IDENTIFY?
There are many “grey” areas in a 1031 tax-deferred exchange, but the timelines and identification requirements are two areas that are black and white. You must acquire a property that was identified within the 45-day identification period for your exchange to qualify for tax deferral.
WHAT HAPPENS IF I DO NOT IDENTIFY ANYTHING?
If you have not identified replacement property by midnight of the 45th day, the exchange will be canceled and your exchange proceeds will be returned to you, minus any withholding tax required by your specific state.
ARE THERE ANY POSSIBLE EXTENSIONS TO THE 45-DAY IDENTIFICATION AND 180-DAY EXCHANGE DEADLINES?
Taxpayers who are affected by a Presidentially-declared disaster or who are serving in a combat zone may be entitled to an extension of these two deadlines. Check with your First American Exchange Company representative if you think you may be entitled to an extension on these grounds.
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