IRS has mentioned specific guidelines for identifying and acquiring suitable like-kind replacement properties for your 1031 exchange transaction. Any replacement property/properties that you are contemplating for acquisition in your 1031 exchange must be identified to your Qualified Intermediary. You also need to follow guidelines around the time-period. Your replacement property needs to be identified no later than midnight of the 45th calendar day after the closure of your relinquished property sale transaction.
Let us understand this with an example – If you close the sale of your relinquished property on October 31st, November 1st will be considered as the first day of your 45 calendar identification period, and December 15th will be the 45th calendar day and the deadline. There are specific identification rules which need to be followed while performing the identification of your like-kind replacement properties:
Three (3) Property Identification Rule:
The three (3) property identification rule restricts the total number of suitable like-kind replacement properties that you can identify to a maximum of three properties. Investors prefer the three property identification rule as it benefits them vastly.
You are permitted to acquire all three of the identified like-kind replacement properties for your 1031 exchange. However, investors mostly acquire only one of the three identified properties. The second and third identified properties serve as a back-up replacement property in case you fail to acquire the first property.
You can also choose to skip the three property identification rule and use the 200% of Fair Market Value Rule, which will allow you diversification of your investment portfolio.
200% of Fair Market Value Identification Rule:
As per this rule, you can identify more than three like-kind replacement properties till the time the aggregate fair market value of all the identified like-kind replacement properties does not exceed 200% of the total net sales value of your relinquished property(ies) closed in your 1031 exchange. The restriction only applies to the total (aggregate) identified value.
Let us understand this with an example – If you closed relinquished property(ies) in the amount of $3,000,000 you are permitted to identify as many like-kind replacement properties as you wish till the time the total value of the identified like-kind replacement properties does not exceed $6,000,000 (200% of $3,000,000).
95% Identification Exception:
This rule is a little tricky and is only useful under a few extreme circumstances.
You might require to identify more like-kind replacement properties than the allowed by the first two identification rules. There is no restriction on the total number or value of identified like-kind replacement properties sanctioned under the 95% exception until the time you actually acquire and close on 95% of the value identified.
However, if you do not acquire and close on at least 95% of the value of the identified like-kind replacement properties, IRS can disqualify your entire 1031 exchange.
It is challenging for investors to follow the strict 45- or 180-day timelines. This is when Delaware Statutory Trusts (DSTs) can come to your rescue. DSTs are pre-packaged and can close within 3-5 days. We like to consider DSTs as a protection plan because there is no surety that the investor will definitely be able to settle on their first choice or possibly even their second choice property. We recommend identifying DST properties as a third option.
The ability to defer taxes using a §1031 exchange is a valuable benefit to taxpayers. However, to receive this benefit, all the exchange rules must be followed correctly. The provisions of identification and receipt of replacement property must be understood and met to complete a successful exchange. If anyone these rules are not in accordance, IRS may disqualify the exchange and also levy additional penalties.
If you are looking to complete a 1031 Exchange and searching suitable properties, feel free to contact us. We have more than 15 years of experience managing highly profitable exchange for our investors. We have access to suitable off-market premium-grade properties ideal for 1031 Exchange. To obtain a FREE PROPERTY LIST, click here.