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Understanding the 1031 Exchange Identification Rules

December 21, 2023

The IRS stipulates a set of rules and requirements that you must comply with during the property identification and acquisition process to ensure a successful 1031 exchange. Understanding these rules and requirements will help you identify potential pitfalls that can jeopardize the 1031 exchange process and avoid them.

At Universal Pacific 1031 Exchange, we can help you understand and comply with the identification rules to be sure you maximize the tax benefits of your property exchange. With over 32 years of experience handling successful exchanges, you can trust us for expert guidance throughout the process. Schedule a free consultation with us now to get started.

In this article, you’ll learn about the 1031 exchange identification rules, factors to consider when identifying replacement properties, common investment property identification mistakes and how to avoid them, and other important things you need to know.

The Key Identification Rules in 1031 Exchange 

The Key Identification Rules in 1031 Exchange 

Violation or misinterpretation of any of the property identification rules while identifying prospective replacement properties may disqualify your exchange from tax deferral. These rules include:

The 45-Day Identification Period

The 45-day identification rule stipulates that the taxpayer has 45 days from the sale of the relinquished property to identify a replacement property. Where the taxpayer relinquishes more than one property at different times, the 45-day timeframe starts from the day of the closing of the first relinquished property. The identification must be made in writing, signed and dated by the taxpayer, and delivered to the qualified intermediary or other party involved in the exchange within this timeframe.

Note that the identification must not be made to a disqualified person. This is to prevent the manipulation of the rule to the taxpayer’s favor. A disqualified person is an individual or entity that has close relationship or business ties with the taxpayer. They include the defendant’s family member, employee, attorney, or the accountant of the taxpayer.

The identification document must contain a detailed description of the identified property to avoid ambiguity, enable easy and clear identification, and ensure compliance to the IRS rules. Failure to meet the 45-day identification period can disqualify the exchange, resulting in the taxpayer incurring capital gain tax.

The 180-Day Timeline

The 180-day closing period requires the taxpayer to complete and acquire the identified replacement properties within 180 days following the sale of the relinquished property. It’s important to note that the 180-day period runs concurrently with the 45-day identification period, which means you have 135 days after you identify replacement property to finalize the exchange. Additionally, the 180-day period includes only calendar days, not business days.

To ensure compliance with the IRS guidelines, you must acquire the ownership and finalize all relevant paperwork within the 180-day purchase timeline. Note that you may need to file an extension to your tax returns if the 180-day period aligns with the tax filing deadline. This will help you gather necessary paperwork and complete the exchange.

The Three-Property Rule

The Three-Property Rule

The three-property rule allows the taxpayer to identify up to three replacement properties irrespective of their fair market values. It’s optional to acquire the three properties but the taxpayer must acquire at least one of the properties within the 180-day purchase period.

The 200% Rule

In the 200% rule, you can identify and close on more than three properties as long as their aggregate fair market value does not exceed 200% of the fair market value of the relinquished property. Unlike the three-property rule, the 200% rule does not limit the number of properties identified. However, it places a limit on the total market value to prevent the taxpayer from overreaching in their identification.

The 95% Rule

Here, there’s no limit on the fair market value or the number of replacement properties you can identify. However, you must acquire at least 95% of the aggregate fair market value of the identified properties.

For example, assuming the fair market value of the relinquished properties is $5 million, and you identified up to 4 properties with an aggregate fair market value exceeding $10 million. Your identification would only be valid if the value of the properties you acquired is worth at least $9.5 million. Practically, this rule may be challenging since it compels the taxpayer to acquire all the identified properties.

Factors to Consider When Identifying Potential Replacement Properties

Factors to Consider When Identifying Potential Replacement Properties

1. Property Type

The relinquished properties and the replacement properties must be like-kind, meaning they must be of the same nature, character, or class. Properties that are held for investment or business purposes qualify as like-kind.

This means you can exchange your apartment building for a shopping center, a commercial building for raw land, or a hotel building for condominiums. Personal properties such as residential or vacation homes are not regarded as like-kind, and therefore do not qualify for a 1031 exchange.

2. Location

Properties located in areas with high economic growth, low crime rate, and access to basic amenities tend to appreciate in value over time. Conversely, properties in areas with high crime rates, prone to natural disasters, and low desirability may experience depreciation.

Consider demographic factors and economy of location before you acquire replacement property. This will help you assess the risks and the cash flow potential of the investment. Also, you should consider the proximity of the real property to your residential location, especially if you intend to manage it yourself.

3. Financial Considerations

Evaluate the purchase price, potential ROI, operating costs, access to loans or other financing methods that will help you to acquire and manage the property. Consider the interest rates and the loan terms and conditions to help you determine the feasibility of acquiring the property.

You should also consider the overall market condition and the appreciation potential of the property, which is crucial for long-term investment success. To do this, research the market trends, population growth rate, infrastructure development, and job and business growth in the area.

4. Your Investment Goal and Risk Tolerance

Your potential replacement properties must align with your investment goals and risk tolerance. Are you looking for long-term appreciation, a regular income flow, or both? This will help you determine the type of replacement property to acquire.

For example, if your investment goal is to generate steady income, you may focus on acquiring rental properties in a location with high population and economic development.

If you have low risk tolerance, you may invest in residential rentals in an established area with a stable appreciation and demand. If you have a high risk tolerance, you may explore the emerging real estate market or acquire properties in developing areas.

Common Property Identification Mistakes and How to Avoid Them

Common Property Identification Mistakes and How to Avoid Them

Failure to Adhere to IRS Timeline

Sometimes, the 45-day timeline may seem not enough to find a replacement property that suits your budgets and investment goals. This may potentially result to defaulting the IRS identification timeline. Also, emergencies and unexpected change in financial status may make the taxpayer unable to close on the replacement property within the 180-day purchase period.

To avoid this, plan ahead and start looking for a potential replacement property well in advance. Also, make plans for contingencies related to financing, property inspection problems, and seller delays. It’s recommended to work with an experienced qualified intermediary to help you navigate the process with ease.

Not Meeting Identification Requirements

Your identification must be made in writing, duly signed and dated, and delivered to the qualified intermediary and any other relevant entity involved in the process. You may not be able to successfully defer capital gains taxes if you fail to adhere to these guidelines. You should study the IRS guidelines that govern the 1031 exchange to help you identify potential pitfalls and avoid them.

Not Consulting with a Tax Advisor

A tax advisor is experienced in tax laws and can help you navigate the process, ensuring you meet all the requirements that qualify you for tax deferral.

Find a reputable tax advisor near you. Be sure to check their credentials, such as Certified Public Accountant (CPA) and Accredited Tax Advisor (ATA). You may also seek recommendation from friends, family or colleagues who have had positive experience with a tax advisor.

Not Using Like-Kind Properties

Use of personal properties like primary residence and properties held primarily for flipping purposes (inventories) goes against IRS guidelines, as they’re not regarded as like-kind properties. To avoid this mistake, meet with a tax professional to ensure the identified properties complies with IRS guidelines.

Conclusion

Understanding and complying with the 1031 exchange identification rules will help you ensure a successful 1031 exchange. On the other hand, failure to follow these rules can result in automatic disqualification from the tax deferral benefits.

If you’re looking for a reputable Qualified intermediary, then look no further. Universal Pacific 1031 Exchange is here to help you achieve a smooth and successful 1031 exchange. Book a free consultation call with us now.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.