For a successful 1031 exchange, it is important to understand and comply with the 1031 exchange identification rules. These rules are not that complicated, but a failure to follow the rules may ruin your exchange. Here are the top ten things to remember when identifying replacement property in an exchange:
1. Deadline and General Rules. The taxpayer has 45 days from the date that the relinquished property closes to identify the replacement property that he intends to acquire in the exchange. If there is more than one relinquished property in one exchange, the 45 days are measured from the date the first relinquished property closes. The property identified does not have to be under contract, and the taxpayer does not have to acquire everything that he identifies. It is important to note, however, that the taxpayer is not allowed to acquire anything other than the property that he has identified, and a failure to comply with the identification rules can ruin the whole exchange.
2. 3 Property Rule. There are rules that limit how many properties the taxpayer may identify. In most cases taxpayers use the three property rule. The taxpayer may identify up to three replacement properties and may acquire one, two or all three of those.
3. 200% Rule. If the taxpayer wants to identify more than three properties, he can use the 200% rule. This rule says that the taxpayer can identify any number of replacement properties, as long as the total fair market value of what he identifies is not greater than 200% of the fair market value of what was sold as relinquished property. First American Exchange recommends that taxpayers build in a “cushion” by identifying properties that are worth less than what is permitted, in case some properties are later determined to have a higher value than what was originally estimated.
4. 95% Rule. There is another rule that is not commonly used by investors. The 95% rule says that a taxpayer can identify more than three properties with a total value that is more than 200% of the value of the relinquished property, but only if the taxpayer acquires at least 95% of the value of the properties that he identifies. Essentially, the taxpayer will need to acquire everything that he has identified to make this work, and that is why it is not relied on too often.
5. Property Acquired in 45 Day Period. Any property that is actually acquired during the 45 day identification period is deemed to be properly identified. It’s important to note that if some property is acquired during this period and some property is acquired later using another one of the identification rules, the property acquired during the first 45 days needs to be counted as one identified property. For example, if you acquire one property during the first 45 days and you plan to use the 3 property rule and buy more properties after the 45 days, you only have two more properties to identify because you have already used up one.
6. Manner of Identification. The identification must be in writing and signed by the taxpayer, and the property must be unambiguously described. This generally means that the taxpayer identifies either the address of the property or its legal description. A condo should have a unit number, and if the taxpayer is buying less than a 100% interest, the percentage share of what is being acquired should be noted.
7. Who Must Receive the Identification. The taxpayer must send the identification notice either to: 1) The person obligated to transfer the replacement property to the taxpayer (such as the seller of the replacement property) or; 2) To any other person “involved” in the exchange (such as the qualified intermediary, escrow agent or title company), other than a “disqualified person,” such as an agent or family member of the taxpayer. Most identification notices are sent to the qualified intermediary.
8. Replacement Property Must be Same as What Was Identified. The taxpayer must receive “substantially the same” property as he identified. The regulations contain four examples to illustrate what “substantially the same” means. In one example, the taxpayer identifies two acres of unimproved land and then acquires 1.5 acres of that land. The property acquired is substantially the same because what the taxpayer received was not different in nature or character from what was identified, and the taxpayer acquired 75% of the fair market value of the property identified. In another example, the taxpayer identifies a barn and two acres of land, and then acquires the barn with the land underlying the barn only. The IRS says that the property acquired was not substantially the same as the property identified because it differed in its basic nature or character.
9. Property to be Constructed. If the replacement property is under construction at the time of identification, the taxpayer must include not only the address or legal description of the property, but also must include a description of what is to be constructed on the property.
10. Reverse Exchanges. If the taxpayer is doing a reverse exchange where the accommodator acquires the replacement property before the taxpayer closes on the sale of the relinquished property, the taxpayer must identify in writing what he intends to sell and that identification must be sent no later than 45 days after the accommodator closes on the replacement property.