Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Even so, there are do's and don’ts and several gray areas of which taxpayers should be aware. Here at Accruit, we are accustomed to dealing with all types of complex exchanges, and we want to make sure that the complexity of exchange doesn't deter you from considering one. We'll help you put the pieces together for a successful exchange. For the taxable gain to be deferred, specific key requirements must be satisfied:
- Properties Must Be The transfer of the relinquished property to the Qualified Intermediary, and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be properly structured, rather than being a sale to one party followed by a purchase from another party. Exchange d, Rather than Sold and then Purchased
- There Must Be No Constructive or Having direct access to exchange funds or other property. Actual receipt of exchange funds during the exchange period is cause for disqualification of the tax deferred exchange. Compare to Constructive Receipt, below. Actual Receipt of Exchange Funds
- Properties Must be "Like-Kind"
- Must Follow The transfer of the relinquished property to the Qualified Intermediary, and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be properly structured, rather than being a sale to one party followed by a purchase from another party. Exchange Time Limit & Identification Requirement
- Properties Must Be Held for Business or Investment Purposes
- The transfer of the relinquished property to the Qualified Intermediary, and the receipt of the replacement property from the Qualified Intermediary is considered an exchange. To be compliant with IRC Section 1031, the transaction must be properly structured, rather than being a sale to one party followed by a purchase from another party. Exchange Must Be Equal or Up in Value:
- To potentially defer all of the taxable gain, a property owner must first reinvest all of the equity in the relinquished property into the replacement property. Second, the purchase price of the property acquired must equal or exceed the sale price of the relinquished property. Typically, this requires debt on the new property to equal or exceed the debt that is paid off on the relinquished property.
Identification Rules: The 3-Property Rule
The 3-property rule states that the replacement property identification can be made for up to three properties, meaning that an exchanger may identify more than one alternate property to be received in an exchange. The taxpayer can identify and purchase up to three replacement properties after relinquishing their initial property to the qualified intermediary, like Accruit. The amount totaled at the end of the identification is not relevant to the requirements of section 1031, as long as it is not more than three properties. A majority of taxpayers will utilize this rule. Here is an example of the utilization of the 3-property rule: Ms. Garcia begins a 1031 exchange in Minnesota with Accruit, with a lot valued at $325,000. Before identifying her new replacement properties, Ms. Garcia confirmed to Accruit that she has identified three potential properties and intends to acquire only one. Within 45 days Ms. Garcia unambiguously identifies three new properties valued at $325,000, $350,000, and $370,000, respectively. As long as Ms. Garcia receives one of these properties within the replacement period, she has satisfied the 3-property rule.
Identification Rules: The 200% Rule
The 200% rule states that the taxpayer may 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 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.”
Another way to state this is that the taxpayer can identify any number of properties and close on any number of them if the sum of the market value of all of them does not exceed twice the market value of the relinquished property. There is some uncertainty of how the market value of these properties is determined. The listing price? The amount the seller is willing to accept? The amount that the taxpayer agrees to pay? The answer is unclear, but using the listing price would surely be a safe choice. Here is an example of the 200% percent rule: Ms. Garcia is exchanging her lot valued at $300,000. She identifies four new properties, each priced at 100,000. Although Ms. Garcia identified more than three properties, their combined value does not equal more than 200% of the value of her relinquished property. Therefore, it has satisfied the identification rules.
Identification Rules: The 95% Rule
The 95-percent rule is defined as follows:
"Any replacement property identified before the end of the identification period and received before the end of the exchange period, but only if the taxpayer receives before the end of the exchange period identified replacement property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified replacement properties."
As a practical matter, this rule is difficult to adhere to. It provides that should the taxpayer have overidentified for the first two rules, the identification can still be considered valid if the taxpayer receives at least 95% in value of what was identified. For example, suppose a taxpayer identified four properties or more whose market value exceeds 200% of the relinquished property value, to the extent that the taxpayer received 95% of what was identified the identification is deemed proper. In the real world, it is difficult to imagine this rule being relied upon by a taxpayer. Let's use Ms. Garcia as an example again, she is exchanging her $300,000 lot in Minnesota, and she overidentifies a total of 21 lots, each priced at $35,000. Ms. Garcia identified more than three properties and exceeded 200% of the value of her relinquished property. However, she can still keep her exchange valid if she purchases at least 95% of the value of those 21 lots she identified. If Ms. Garcia instructs her intermediary to convey at least 20 of those lots during the replacement period, she has satisfied the identification rules because she is purchasing at least 95% of the $735,000 she identified, and her exchange is still valid.
The relinquishment and replacement of properties are vital components of 1031 exchanges. Navigating the regulations in a 1031 exchange can seem daunting, and there are many questions throughout the process. Can you buy two properties in a 1031 exchange? What are the 1031 exchange rules in Florida or Kentucky? It is strongly recommended that you discuss your exchange with your tax and legal advisors along with a qualified intermediary. Accruit's leadership team has over 200 years of combined experience working with taxpayers and their advisors in structuring successful 1031 exchanges.
At Accruit, we handle all types of complex exchanges. Have a situation you'd like to speak to an expert about? No problem. We're happy to have a free, no-obligation consultation with you.