You’ve identified a property within your investment portfolio that isn’t quite right. Maybe it’s not making you enough money, or perhaps it’s not in the right location. A 1031 exchange could help you to trade it for something better, but you must follow the rules to make it work.
Some rules involve identification—how you officially name a property (or properties) that you’ll purchase as part of an exchange.
These are the 1031 exchange identification rules you should know about.
What Is a 1031 Exchange? A Recap
A 1031 exchange is a coordinated transaction involving a property for sale and a property (or properties) to purchase. As part of this deal, the capital gains tax from the sale are rolled into the purchase. They don’t become due until that replacement property is sold.
An exchange involves a series of coordinated steps. An investor sells a property and places the funds with a qualified intermediary. Then, the investor identifies a new property and purchases it with the funds from the intermediary. The investor never touches the funds directly. Instead, the money is part of a coordinated transaction involving at least two properties.
The Internal Revenue Service (IRS) has very strict rules about exchanges—and that makes sense, as they allow people to defer the taxes they must pay. Breaking even one of the rules means that the transaction is no longer part of an exchange, and the taxes you hope to defer are due immediately.
Why Is an Exchange Identification Required?
As we mentioned, a 1031 exchange is more complex than the sale of one property and the purchase of another. This is a coordinated transaction involving two very important moving parts. To ensure that you’re not simply selling and buying, the IRS requires buyers to identify what they want to buy.
After the exchange property is identified, the purchase must involve an asset that’s like-kind (substantially similar to the one that was listed in the official documents).
1031 Exchange Identification Rules You Should Know
Now that we’ve explained what an exchange is and why identification is important, let’s dig into the rules you must follow to complete these transactions.
1. You Have 45 Days to Identify
One very important rule involves a deadline. After you’ve sold a property, you have 45 days to identify the property (or properties) that will replace it as part of the exchange. This deadline can’t be shifted, even if you face something serious like an illness or family emergency.
To ensure that you meet this requirement, your identification documents must be clearly dated. The documents should also be delivered in a permanent form (like a hard copy), so no one can accuse you of falsifying the document later on and fudging the dates.
2. Only Commercial Properties Can Be Identified
An exchange is designed for investments, not for personal profit. That means the properties you identify for your 1031 exchange must be held for use as an investment or business.
For example, you could identify things like apartment buildings, rental homes, office parks, and warehouses. You can’t identify things like single-family homes you intend to live in full-time.
3. You Can Only Identify 3 Properties
You’re not required to go into a sales contract before you identify a property. And sometimes, real estate deals don’t go as planned. A property you might want could become unavailable for purchase, therefore invalidating your exchange.
Some investors try a workaround and list several properties in their identification documents. However, you’re not allowed to list more than three properties. This rule ensures that investors don’t try to list everything in their communities that they might buy at some point.
4. You Must Meet the 200% Rule
If you choose to identify multiple properties, you must meet rules about how much they’re worth. That’s where the 200% rule comes in.
You must identify the fair market value of all properties and add up those figures. The total value can’t be larger than 200% of the fair market value of the property you sold.
These numbers can’t be shifted and altered, so it’s smart to overestimate how much each replacement property is worth. If you still can’t make the numbers work, you may need to remove one item from the list.
5. You Must Also Meet the 95% Rule
We’re still not finished with math and percentages. This rule also applies to investors who choose to list more than one property on their identification documents.
Per this rule, you must acquire at least 95% of the value of all the properties you identify. In other words, you must ensure that all of these deals come to pass and that you purchase the majority of all of them.
This rule is a hard one to meet. As a result, most investors just identify one property in their documents. With this method, they can focus exclusively on making one deal come to pass, rather than trying to complete three transactions.
6. Your Property Must Be Described Properly
As you might expect from official documents, specificity is key. You can’t make vague and general statements about where the property is and what it looks like. Instead, you must be very clear about the property. In fact, your documents must be so detailed that anyone reading them could hop in the car and drive right to it.
To describe the property correctly, you should provide its street address. If you’re buying just part of a property (like one unit in an apartment building), that should be included as well. If the property has a distinguishable name (like The Old Mill or something stamped on the building), that should be included as well.
7. Your Identification Must Be in Writing
Real estate transactions can take months to complete, and you likely have several conversations with friends, family, and officials. None of these conversations can serve as your official exchange identification.
You must create an official document, so that means verbal conversations don’t qualify. To ensure you meet this requirement, create a document on a computer and print it out. While some say that things like an email can count as an official identification, it’s not as safe as printing a document.
8. You Must Sign the Document
A 1031 exchange identification is an official document that you might be required to show to an official entity (like the IRS). While you’re not required to have your paperwork notarized, you are required to sign it. A lawyer or legal representative can’t do this for you. Instead, you must sign the paperwork yourself.
This rule explains why something like an email isn’t as safe as a printed document. While you can clearly and confidently sign something printed on paper, it’s harder to do that in an email or text message
9. Someone Official Must Get the Document
IRS rules require you to deliver your exchange identification to a person involved in the exchange. That could mean the seller of the replacement property or your qualified intermediary. You can’t send the documents to someone like a real estate agent and call it good.
To ensure that you meet this requirement, deliver the document officially. Hire a courier to take it to the person and ask for proof that the work was done. Keep that document with your important exchange paperwork in case you’re asked for proof later.
Who Should Help With an Exchange?
Keeping track of all of the 1031 exchange identification rules—and all of the other requirements involved in these transactions—isn’t easy. You also can’t do this work alone, as you’re required to use a qualified intermediary to hold the funds from the sale and release them for the purchase at the right time.
Consider working with us here at 1031 Pros. We specialize in these types of transactions and have helped people just like you make the most of their real estate opportunities. We always protect our clients’ funds, and we offer a level of expertise that others just can’t match. Contact us to find out more and sign up for our services today.
References
Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service.
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