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Practical Application of Identification Rules in a 1031 Exchange
The identification phase in a 1031 Exchange is a critical step that involves identifying potential Replacement Property(ies) within a strict 45-day timeline, making it essential to understand the rules and strategize effectively. Our case study discusses how and why an Exchanger might use each of the three Identification Rules based on their reinvestment goals. By putting these rules into action, we can examine potential challenges and provide valuable insights for investors aiming to navigate the complexities of a 1031 Exchange successfully.
What are Identification Rules?
In a 1031 Exchange, an Exchanger has 45 days from the date of sale of a Relinquished Property to identify potential Replacement Property(ies). This period is known as the identification period and entails adherence to specific requirements to ensure the validity of the exchange. There are three distinct Identification Rules that an Exchanger can utilize when identifying Replacement Property in a 1031 Exchange, including the 3-property rule, 200% rule, and 95% rule. These rules were put into place as a part of the 1991 Treasury Regulations to provide clarity and instruction on the timing and identification of Replacement Property(ies) in 1031 Exchanges. Prior the 1991 Regulations, Exchangers were still required to identify potential Replacement Property(ies), but did not have restrictions on the number they could identify. However, Exchangers were obligated to rank properties and were only allowed to acquire properties further down their list if the sale of the prior property fell through for reasons outside of their control. The 1991 Regulations offered more flexibility and guidance in the identification process of 1031 Exchanges.
The 3-Property Rule:
The most commonly used rule is the 3-property rule. This rule permits the identification of up to three Replacement Properties regardless of their fair market values. When Section 1031 was amended in 1984 to impose the 45-day identification period, Congress was concerned that too much flexibility in varying the Replacement Property(ies) would make the transaction appear to be more of a sale than an exchange. This concern influenced the 1991 Treasury Regulations, where the 3-Property Rule was established.
The 200% Rule
The 200% rule allows Exchangers to identify any number of properties, so long as their total fair market value at the end of the identification period does not exceed 200% of the aggregate fair market value of the Relinquished Property(ies) at the time they were transferred. Simply put, Exchangers can identify any number of properties if their combined market value does not exceed twice the market value of the Relinquished Property(ies). There is some uncertainty regarding how the market value is determined - whether it's based on the listing price, the seller's acceptable price, or the agreed-upon purchase price. Using the listing price is generally considered a safe choice.
The 95% Rule
The final identification rule, which is seldom utilized due to the complexity of meeting the requirements, is the 95% rule. The 95% rule allows Exchangers to identify any number of Replacement Property(ies) regardless of fair market value in relation to the Relinquished Property values, but they must acquire at minimum 95% of the fair market value of all identified properties. Essentially, if an Exchanger has over-identified properties for the first two rules, the identification can still be considered valid if the Exchanger receives at least 95% of the total value of all of the identified properties. For instance, if an Exchanger sold one property for $100,000 and identified five properties of various values totaling $300,000, they would need to acquire at least $285,000 of identified value. In practice, this usually means that the Exchanger must buy all of the identified property. In practice, this rule is very challenging to adhere to and carries the most risk of the Exchanger being unable to satisfy the identification requirement potentially resulting in a nullified Exchange and taxable event.
Identification Rules Employed in a 1031 Exchange
We will now look at a hypothetical case study of an Exchanger in the identification phase of their exchange, testing different identification strategies to figure out which is the right fit for their exchange.
Our Exchanger is a real estate investor looking to defer capital gains taxes by utilizing a 1031 Exchange. They engaged Accruit as the Qualified Intermediary for their 1031 Exchange prior to the sale of their multi-family rental property for $1,000,000. Now, they need to identify potential Replacement Property(ies) within 45 days. We will review how they might use each of the identification rules: the 3-Property Rule, 200% rule, and 95% Rule in their 1031 Exchange.
The 3-Property Rule Attempt:
Our Exchanger aims to leverage the 3-Property Rule, which allows them to identify up to three potential Replacement Property(ies) without considering their total value relative to the Relinquished Property.
The Exchanger identifies the following properties:
Property A: An apartment building valued at $1,000,000.
Property B: A retail space valued at $1,300,000.
Property C: A mixed-use property valued at $1,200,000.
The Exchanger successfully identifies these three properties within the 45-day identification period and has the option to acquire one or more of the three properties for a successful exchange.
For the sake of demonstration, let’s say our Exchanger wants to identify not three individual properties, but one individual property and then a Delaware Statutory Trust (DST) portfolio of properties. If more than three properties are to be identified, our Exchanger is unable to use the 3-Property Rule and therefore the Exchanger must look to the 200% rule instead.
The 200% Rule Attempt:
Our Exchanger will try to utilize the 200% Rule, which allows them to identify any number of properties (greater than three) so long as their combined fair market value does not exceed 200% of the value of the Relinquished Property. In this example, the allowed combined market value of the identified properties would be $2,000,000 since the Relinquished Property sold for $1,000,000.
Identification:
Property A: An apartment building valued at $1,000,000.
Property D: A DST portfolio of 6 properties including multi-family and retail properties valued at $1,000,000
Total value of identified properties: $2,000,000, satisfying the 200% rule requirements.
For illustrative purposes, let’s say our Exchanger wants to identify all three properties in our example - Property A, Property B, and Property C, in addition to Property D, the DST portfolio.
The Exchanger identifies the following properties:
Property A: An apartment building valued at $1,000,000
Property B: A retail space valued at $1,300,000
Property C: A mixed-use property valued at $1,200,000
Property D: A DST Portfolio valued at $1,000,000
The total fair market value of the identified properties of $4,500,000 exceeds 200% of the Relinquished Property value, and therefore the 200% rule cannot be utilized, and the Exchanger must seek to comply with the 95% rule.
The 95% Rule Attempt:
Our Exchanger identifies three Replacement Property(ies) within the 45-day identification period:
Property A: An apartment building valued at $1,000,000
Property B: A retail space valued at $1,300,000
Property C: A mixed-use property valued at $1,200,000
Property D: A DST portfolio valued at $1,000,000
The total fair market value of the identified Replacement Property(ies) is $4,500,000.
The Exchanger plans to use the 95% Rule, which requires them to acquire at least 95% of the total fair market value of all identified properties. This means they must acquire properties worth at least $4,275,000 (95% of $4,500,000) by the end of the 180-day exchange period.
It should not go without note that this rule is difficult to successfully adhere to and is rarely used as a result. Our Exchanger is now in the position where they must actually acquire all four of these identified properties for their identification to remain valid and the 1031 Exchange to be successful.
Another example may help to clarify this requirement. Our same Exchanger sold the same $1,000,000 property, but has now identified the following four properties:
Property A for $625,000
Property B for $750,000
Property C for $125,000
Property D for $1,000,000
These four potential Replacement Properties also total $4,000,000 in aggregate fair market value. For the exchange to be successful, our Exchanger must complete the acquisition of at least $2,375,000. If they acquire Property A, Property B, and Property D ($625,000 + $750,000, + $1,000,000 = $2,375,000), their exchange will succeed.
How to Determine the Proper ID Rule in a 1031 Exchange
For a 1031 Exchange, the determination of which of the identification rules to utilize really comes down to the goals of the Exchanger and which identification rule will help them achieve that goal.
For example, if an Exchanger’s goal is to sell one property in one real estate market and acquire a single Replacement Property in a different real estate market, the 3-property rule would likely suffice. However, if the Exchanger wants to diversify their real estate portfolio and dispose of one, large asset and reinvest into multiple lower value assets, they will likely be looking to invest in more than three properties and therefore would need to utilize the 200% rule. The 95% rule is generally used if the Exchanger sells one very large asset and seeks to diversify into many smaller assets while increasing their debt-to-equity ratio along the way. In practice, when an Exchanger relies on the 95% rule, they almost always buy everything on their identification list.
In a 1031 Exchange, it is critical to choose the appropriate identification rule based on individual circumstances, such as financial constraints and market dynamics, to maximize the benefits of a 1031 Exchange. By understanding the nuances of each rule, Exchangers can maximize the benefits of an exchange, avoid potential pitfalls such as boot, and successfully defer capital gains (and potentially other) taxes. Strategic planning and a thorough understanding of the 1031 Exchange identification rules with the assistance of a Qualified Intermediary (QI) are essential for real estate investors looking to optimize their investments and ensure compliance.
The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary, and as such does not offer or sell investments or provide investment, legal, or tax advice.
