1031 Exchange Rules for Identification and Receipt of Replacement Properties
Understanding identification rules for Internal Revenue Code (IRC) Section 1031 is critical to ensuring the success of your 1031 exchange. These regulations, part of the Tax Reform Act 1984, have stayed the same over the years, and here we discuss the specific rules for the identification and receipt of replacement property.
Why Must You Identify Replacement Property?
In a normal 1031 exchange or tax-deferred exchange, a taxpayer has 45 days after selling their relinquished property to identify a possible replacement. This is also known as the identification period. The taxpayer then has 180 days — less time in some cases — to purchase one or more identified properties. This is known as the exchange period.
If properties are actually acquired within the 45-day identification period, taxpayers don't have to specifically identify them. However, these properties qualify for the three-property and 200% rules, which we'll discuss later in this blog.
These rules originate from the Starker vs. United States case in 1974, where the court allowed a taxpayer to sell relinquished property on one day and obtain a replacement five years later. Before this judgment, the belief was that an exchange had to happen simultaneously. As a result, Congress introduced the 45/180-day limitation as a compromise.
Rules for Identification and Receipt
1031 exchange identification rules include:
• Identifying replacement property within 45 days
• The three-property rule
• The 200% rule
• The 95% rule
• The incidental property rule
• Description of the replacement property
• Replacement property to be produced
The 45-Day Rule
Exchange regulations state that: "The identification period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the 45th day thereafter."
The identification has to:
• Appear in a written document
• Be signed by the taxpayer
• Be delivered to the replacement property seller (or anyone else who isn't a disqualified person) involved in the exchange
It's customary for a qualified intermediary to receive identification. However, a document in a purchase contract stating the buyer identifies the subject property as a replacement can also suffice.
A disqualified person might bend identification rules based on their relationship with the taxpayer, so they cannot receive identification. This person might be a taxpayer's attorney, accountant, investment banker, employee, or real estate agent who provided services during the two years before the transfer of the relinquished property.
Identifications made during the 45-day window can be canceled and substituted with new ones within the identification period.
The Three-Property Rule
The three-property rule states that replacement property identification can occur for up to "three properties without regard to the fair market values of the properties."
Previously, there was a requirement to prioritize identified properties in a 1031 exchange. If a taxpayer wanted to obtain a second identified property, they had to wait until the first identified property fell through because of circumstances outside their control. This requirement presumably led to the 1991 Treasury Regulations, which introduced the three-property rule and that most taxpayers rely on today.
The 200% Rule
This rule mandates that a taxpayer can identify: "Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200% of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer."
In other words, the taxpayer can identify any number of properties (and close on them) if the total market value isn't higher than twice the market value of the relinquished property.
Confusion surrounds how to work out the market value of these properties. For example, should you use the listing price, the amount the seller agrees on, or the amount the taxpayer is willing to pay? To be safe, use the listing price.
The 95% Rule
The 95% rule can be difficult to comply with. It states that if a taxpayer has over-identified because of the first two rules, the identification is still valid if the taxpayer receives at least 95% of the amount of the property identified.
Say a taxpayer identifies four properties with a market value higher than 200% of the value of the relinquished property. The identification is legitimate if the taxpayer receives 95% of their overidentification amount. As a result, it would be hard for a taxpayer to rely on this rule.
The Incidental Property Rule
The incidental property rule states: "Solely for purposes of applying this paragraph (c), property that is incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if - (A) In standard commercial transactions, the property is typically transferred together with the larger item of property, and (B) The aggregate fair market value of all of the incidental property does not exceed 15% of the aggregate fair market value of the larger item of property."
Say incidental property passes to a buyer in a commercial transaction for this type of property sale. The taxpayer doesn't need to separately identify that property if it's less than 15% of the primary property.
Let’s use an example of an apartment building to explain this rule. The building, which a taxpayer will obtain for $1 million, includes furniture and other belongings with a value that doesn't exceed $150,000. Therefore, the taxpayer doesn't need to identify those separate items.
The incidental property rule applies to identification, and taxpayers must ensure their replacement property is still "like-kind" to their relinquished property. Say the relinquished property was real estate and valued at $1 million, while the replacement property was real estate and valued at $850,000 plus had incidental property of $150,000. The taxpayer will need to pay tax — also known as boot. That's because the incidental property wasn't like-kind to the relinquished property.
Description of Replacement Property
The description of a replacement property needs to be clear and precise. For example, the following isn't an accurate description because it doesn't identify the specific unit: "A condominium unit at 1234 Main Street, Atlanta, GA"
The detailed rules for the description of a replacement property are:
• The replacement property must be clearly described in the written document or agreement.
• A clear description of a real property typically includes a legal description, street address, or identifiable name — for example, the Peachtree Apartment Building.
• A clear description of personal property includes a detailed description of the property type — for example, a description of a vehicle that includes its exact make and model.
1031 Exchange Properties That Taxpayers Improve or Produce
Properties intended to be obtained by a taxpayer will often be in a different physical state at the time of identification than at the time of receipt.
Regulations require that real estate identifications consist of an address or legal description of the property and as much detail as possible about the taxpayer's planned improvements. Even if those improvements are not complete at the time of receipt, an exchange is valid if the actual property received doesn't differ from the taxpayer's identification — except for the extent of improvements already completed.
It’s important to note that there are different rules for personal property, and taxpayers should complete all planned improvements within the 180-day window to remain compliant.
Conclusion
Deferring taxes through a 1031 exchange can provide multiple benefits. However, taxpayers must understand and comply with all exchange rules, especially those relating to the identification and receipt of replacement property. These rules are so critical for a successful exchange that the IRS asks taxpayers if they have complied with them on Form 8824.