The Three Basic Rules You Need to Know When Designating a 1031 Property
Written By Diane Schaefer, CES™ and President of Exchange Solutions, Inc., N.Y.
Identifying replacement property under IRC Section 1031 is a precise exercise.
When designating property, taxpayers need to be educated as to how to identify property in order to make for a seamless process. I find many taxpayers are led to believe that the identification process does not have to be specific and there are no limits as to the number of properties that can be identified.
This article is intended to establish the groundwork for the identification process of exchange property by explaining the three basic rules and some potential pitfalls of the identification process.
The three basic rules are the threeproperty rule, 200% rule, and 95% rule. Each rule is exclusive from the other; therefore, you would only use one rule at a time and not a combination of the three. Taxpayers quite often confuse or combine these rules prior to the designation because they are misled in this area of the exchange process.
The first rule is the most common rule, the three-property rule. A taxpayer can identify one, two or three properties and acquire one, two or all three properties regardless of the property’s fair market value. However, a taxpayer wants to keep in mind that the best scenario is to trade equal or greater in value from the relinquished property sold.
If more than three properties are to be identified, a taxpayer may choose to identify under the 200% rule. When identifying under this rule, the taxpayer must list each property’s fair market value. The fair market value must be identified within the 45-day identification period. I alert the taxpayer to this deadline, because if the fair market value of one of the properties changes and its value increases after the 45th day, but before the closing, then the taxpayer will violate the 200% rule if all identified properties are acquired. The total aggregate fair market value of all properties identified cannot exceed double the sales price of the relinquished property sold. If the taxpayer identifies more than three properties and the total fair market value, collectively, exceeds the 200% rule, then the taxpayer is perceived to have not identified any property at all. Caution to the taxpayer exchanging a portion of the relinquished property; this will cap the designation since you are doubling only the portion of the sale property that was exchanged. For example, if a taxpayer only exchanged 60% of a $1 million property, then under the 200% rule, the taxpayer is limited to designating properties with fair market values collectively totaling $1.2 million and not $2 million.
Should a property actually be acquired within the 45-day identification period, the taxpayer officially identified the property and does not need to send a separate identification letter. Regardless if the 200% or three-property rule was used, the taxpayer validly identified and purchased replacement property even if they later violate either of these two rules during the exchange period.
The third rule is the 95% rule, wherein a taxpayer must acquire 95% of the total aggregate fair market value of all properties identified. This fair market value can be determined up to the day of closing or by day 180 of the exchange period, whichever comes first. Caution to the taxpayer that identifies properties where the fair market value, collectively, either increases or decreases prior to acquisition; the taxpayer must acquire 95% no matter what was identified. For example, a taxpayer identifies 5 properties with fair market value’s collectively totaling $1 million within the 45-day identification period. On day 150 the taxpayer is ready to close; however, one of the properties’ fair market value increased and now collectively totals $1.2 million. The taxpayer thought they were to acquire (close on) $950,000 in property value, but now the taxpayer must acquire 95% of $1.2 million or $1.14 million in property value. The minimum to be acquired is always 95% and the exchange will be disqualified if the taxpayer acquires a lesser value.
No matter which rule is utilized for designating replacement property, the taxpayer must specifically indicate the rule being utilized and identify property, in writing, by offering the street address, tax parcel information or legal description. Unit numbers must also be designated when designating an apartment, condo or co-op. The taxpayer must sign the identification letter in the same manner as was held under the relinquished property. So if a husband and wife sold property, both the husband and wife must sign the id letter. The letter must be received by either the qualified intermediary or any other qualified party that is not considered an agent of the taxpayer.
A revocation of an identified property should also be in writing and signed by the taxpayer in the same manner. This revocation must also be delivered within the 45-day identification period. Taxpayers can identify and revoke properties without limitation as long as it is properly identified and revoked within the time frame allotted. The majority of intermediaries prefer to be the recipient of these letters so not to confuse the taxpayer as to who is qualified or disqualified to receive the designation and to offer assistance in designating the property before it is too late and the 45 days expire.
For more involved designations, such as partial interest, improvement, construction, build to suit and reverse exchanges, taxpayers should consult their tax advisors and intermediaries at the earliest stage of the 45-day identification period.