If you are an investor who is selling two properties and you want to trade them in a 1031 exchange, a common question is whether those two properties are two separate exchanges or whether they should be combined into one exchange. This article discusses why this issue is important and what you can do to make it more likely that you will get the result you want.
Why It’s Important
One of the reasons why this is so important is that it affects your 45-day and 180-day deadlines. If you have one exchange with two relinquished properties, and the properties close on two separate dates, the deadline for the 45-day identification period and 180-day exchange period are both measured from the earliest closing date. This can create a problem for taxpayers if the second relinquished property closing is delayed.
In addition, whether the two relinquished properties are part of one exchange or two will affect how many properties you can identify. If they are part of one exchange and you are using the 3 property rule to identify, you can only identify a total of three properties for those two relinquished properties to trade into. If they are set up as two separate exchanges, you can identify three replacement properties for each relinquished property.
If you have set up two different exchanges, with both relinquished properties trading into one replacement property, most tax advisors recommend that the identification for each exchange specify the percentage interest of the replacement property that you intend to acquire for that exchange. For example, if relinquished property #1 sells for $450,000 and relinquished property #2 sells for $300,000, and the replacement property is worth $750,000, then in exchange #1, the taxpayer will identify that he intends to acquire a 60% interest in the replacement property ($450,000 is 60% of $750,000).For exchange #2, the taxpayer will identify that he intends to acquire a 40% interest in that same replacement property. If the two relinquished properties are combined into one exchange, there is no need to be concerned about allocating the percentages in your identification.
Another consideration when determining whether to set up one exchange or two is the math to calculate tax deferral. If two relinquished properties are combined in one exchange and you are unable to purchase enough replacement properties to fully defer the total combined gain on the two sale properties, it may be more difficult to determine the allocation between taxable gain that is deferred and taxable gain that is recognized because of the trade down in value. For example, if relinquished property #1 sells for $450,000 and relinquished property #2 sells for $300,000, and you are only able to buy a replacement property worth $300,000, can you treat property #2 as having complete deferral and property #1 as having a failed exchange? Some tax advisors believe you can separate the two sale properties and complete the tax return accordingly, but when the documentation shows both properties under the same exchange agreement and the proceeds are combined into one exchange account, this position may be somewhat aggressive, as the rulings and case law provide little guidance. A more conservative approach may be to open separate exchanges for each relinquished property and to hold the exchange proceeds in separate bank accounts.
How to Establish Separate Exchanges with Multiple Relinquished Properties
When are two separate relinquished properties considered to be two separate exchanges? These factors can affect the outcome:
- Are the properties adjacent to each other?
- Are the two properties a single economic unit, such as an office building and parking structure?
- Are they being sold to the same buyer?
- Is there one purchase and sale agreement or two?
- Are they closing on the same date?
- Are there separate closing statements and escrow instructions?
- Are there two separate exchange agreements and separate bank accounts holding the exchange funds?
Sometimes taxpayers will assume that having two separate exchange agreements will automatically create two separate exchanges, but that may not be the result. Setting up two separate exchange agreements does provide evidence of the taxpayer’s intent to create two exchanges, and depending on the other factors, may be enough to create two exchanges.
When you have more than one property to dispose of, it’s important to evaluate whether you have one or more exchanges and understand the consequences. When considering an exchange, consult with your tax advisor and contact First American Exchange before the sale of your relinquished property. As the national leader in 1031 exchanges, First American Exchange can assist you through every step of the process.
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