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Answering All Your Questions About Property Identification Rules For 1031 Exchange.
Plus, some answers to the questions you didn’t even know you needed to ask.
Concerned about the rules regarding property identification in a 1031 exchange? This article will answer all your questions and help you understand these rules so you can successfully defer your capital gains taxes using a 1031 exchange.
To defer capital gains taxes using a 1031 exchange, it’s essential to follow specific rules. Failure to do so means that your transaction will be recognized as a taxable sale rather than a tax-deferred exchange.
So, to help you navigate the 1031 exchange process, let’s answer all those important questions about how, and when, to identify replacement properties. While we’re at it, we’ll also cover a few other crucial things you need to know in order to successfully complete a 1031 exchange.
Ready? Here we go.
What are the key rules I need to follow when it comes to identifying property for a 1031 exchange?
• “Like-Kind” Property Rule
• 3-Property Rule
• 200% Rule
• 95% Rule
• 45 Calendar Day Rule
What Is The “Like-Kind” Property Rule?
According to IRS rules, only “like-kind” replacement properties may be identified for use in a 1031 exchange. Normally, real properties held for investment or business purposes (and located in the United States) are considered to be “like kind” to each another, irrespective of asset class or grade.
Can I exchange personal property for real property?
No. While both real property and personal property can be exchanged without recognition of capital gains under Section 1031 of the IRC, it is important to note that real property is not like kind to personal property. Strictly speaking, what this means is that real property can only be exchanged for real property, and personal property can only be exchanged for personal property.
Can I exchange US-based property for foreign property?
No. Only property located in the United States (and some U.S. territories) can be exchanged with other US-based properties. In other words, property in the United States is not considered “like-kind” to property located outside of the U.S.A., and vice-versa.
Can I exchange residential property for commercial property? (or vice-versa?)
Yes. Both commercial property and residential property held for investment (as in a rental property) can be exchanged as these are both considered to be “like-kind” properties.
Can I exchange my personal residence or vacation home for investment property?
No. According to IRC section 1031, a personal residence or vacation home may not be exchanged for investment real estate of any kind. Why not? Because these properties are not held for investment or business purposes.
Note: There are other tax shelters for the proceeds of the sale of personal residences.
Can I exchange raw [undeveloped] land for an improved property?
Yes. Undeveloped land may be exchanged for improved real estate, and vice-versa.
Can land conveyed without its property be exchanged with land conveyed with its’ property?
Yes. Land conveyed without its improvements (for example, ground lease ownership) and land conveyed with its improvements (as in a fee simple ownership) are “like-kind” and may be exchanged.
NOTE: Property transferred without its land has special rules:
Any property improvements transferred without land (leasehold interest) may not automatically qualify. For example, a leasehold interest with less than 30 years remaining does not qualify for “like-kind” exchange and is therefore not eligible for use in a 1031 exchange.
Are there specific types of property that are excluded from the 1031 exchange?
Yes. Some property types are explicitly excluded from tax-deferred treatment under IRC Section 1031. Section 1031 does not apply to exchanges of:
• Stocks, bonds, or notes
• Inventory or stock in trade
• Other securities or debt
• Partnership interests
• Certificates of trust
FYI: Both Delaware Statutory Trust and Tenant-in-Common interests are not a part of these specific exclusions and therefore do qualify for 1031 exchanges.
Are there other rules for business/investment properties I need to be aware of?
Yes. One important rule to remember is that you should only identify property held for business or investment purposes.
Why? Because only property that will be held for productive use in a trade or business or for investment qualifies for use in a 1031 tax-deferred exchange. Therefore, it is crucial for an investor to identify property intended for business or investment.
If a replacement property is held with the intent to be used productively in a trade, business or investment and yet turns out to be unproductive, will that disqualify the property for use in the 1031 exchange?
No. What counts is “intent”. So if the replacement property turns out to be unproductive for business, investment or trade, it will not nullify the 1031 exchange.
What if the property I want to exchange is a personal residence or vacation home that is occasionally rented out? Or what if one intends to run a home office out of the property?
Do those properties still qualify as a replacement property in a 1031 exchange?
No. The rule of “Predominant Use” specifies that replacement property in a 1031 exchange must be predominantly used for investment or business purposes. So, if the property is a personal residence or a vacation home it does not qualify, even if it is sometimes rented out or used for a home office.
What if I have a rental property that is occasionally used for personal purposes, can that property be used as a replacement property?
Yes. If the property is predominantly used as a rental and is only occasionally used for personal purposes, it does qualify for use as a replacement property in a 1031
What are “Safe Harbor” limits?
To ensure proper consideration of a property’s status for 1031 exchange purposes it’s important to adhere to “Safe Harbor” conditions as explained in Revenue Procedure 2008-16 which stipulates the conditions under which the IRS will not challenge one’s intent to hold a replacement property for business or investment purposes.
For example, if:
• a property is held for 2 years or more, and
• during each of the 2 years after the exchange it is rented out for 14 days or more, and
• during each of the 2 years after the exchange it is not used for personal purposes for any more than 14 days, or 10%, of the duration for which it is rented out
• then its intent to be held for investment purposes will not be challenged by the IRS.
IMPORTANT: Investors must choose to follow one of these 3 rules below:
• The 3-Property Rule
• The 200% Rule
• The 95% Rule
What is the 3-Property Rule?
Up to 3 potential replacement properties can be identified, regardless of the total market value of the properties. The investor may acquire as many of the properties identified as desired to complete the exchange.
What is the 200% Rule?
One may identify more than 3 potential replacement properties, as long as the combined market value of those properties does not surpass 200% of the market value of the relinquished property. There is no limit to the number of properties the investor may acquire in order to complete the exchange using the 200% Rule.
What is the 95% Rule?
Investors can identify as may potential replacement properties as they like, regardless of their combined market value, as long as the investor acquires 95% of the shared market value of all the properties identified.
What is the significance of these 3 rules?
You must follow either the 3-Property Rule, the 200% Rule or the 95% Rule to successfully defer your capital gains taxes in a 1031 exchange. Failure to comply with one of these identification rules will result in the taxable recognition of capital gains. To follow them requires advance planning.
Keep in mind: Following these rules may obligate an investor to purchase property that might not otherwise be desired in order to achieve compliance and successfully avoid the capital gains taxes.
Is an investor ever allowed to revoke replacement property identifications?
Yes. Investors are allowed to revoke replacement property identifications as long as this is accomplished prior to the 45th calendar day after the close of escrow on the relinquished property. Unrevoked property identifications may not be changed, however.
Why would an investor want to revoke property identifications prior to the 45th calendar day?
An investor might want to revoke a property identification if something were to change with respect to the property. Let’s say a deal fails to materialize, something about the property is uncovered during inspection, the investor changes their mind or they find a better property, for example. In these cases, they would have the option to revoke the property identification.
How long do I have to identify a potential replacement property?
The time period is exactly 45 calendar days long. The first day after the close of escrow is day #1. The replacement property identification must take place by midnight of day #45. Note: If this day falls on a weekend or holiday, the deadline is not extended.
[Use our 1031 Time Limit Calculator.]
Are there any exceptions to the 45 Calendar Day rule?
Yes. But, exceptions are extremely rare and may only be declared by the President of the Unites States; something which has only been done on very rare occasions, such as in the case of a natural disaster that affects the properties or parties involved with the 1031 exchange process.
By what means do I submit my 1031 replacement property identification?
IRC section 1031 requires property identifications to be “hand delivered, mailed, telecopied, or ‘otherwise sent.’” Property identifications today are typically emailed, and recipients reply by email, with the property identifications attached to the reply, to confirm receipt.
To Whom do I submit my 1031 replacement property identification?
The standard practice today is to submit property identifications to one’s Qualified Intermediary, who will be party to the official Exchange Agreement and therefore demonstrably “involved” in the exchange.
Are there other examples of “involved parties” allowed by the IRS I should know about?
Yes. Other IRS-supplied examples of “involved” parties are:
• The person obligated to transfer the replacement property to the taxpayer (which can be different from the Qualified Intermediary in certain circumstances)
• Any party to the exchange
• An escrow agent
• A title company
Note: IRS Fact Sheet 2008-18 specifically disqualifies one’s attorney, real estate agent, accountant, or similar persons who act as one’s agent from receiving one’s 1031 replacement property identifications.
What do I need to include when I submit my 1031 replacement property identification?
Most Qualified Intermediaries have years of experience to help facilitate this process and have standardized paperwork available to make it easy for you. However, at minimum, property identifications must include specific, unambiguous descriptions of each property. This may include legal descriptions, street addresses, Assessors’ Parcel Numbers, and any recognized building names.
NOTE: If you use the 200% rule and are planning to acquire a fractional interest, such as a Tenant-in-Common or Delaware Statutory Trust interest, you need to specify the percentage or the actual dollar amount being considered for acquisition.
Why is this important?
Because failure to do so may be interpreted as an identification of the entire property. If you don’t specify the fraction, the IRS could argue that you technically identified the entire thing, which would most likely result in a violation of the 200%, triggering a taxable event.
Would signing a contract or closing escrow on a replacement property satisfy the property identification requirements?
Yes. If a Letter of Intent (LOI) or contract is signed by its parties prior to the end of the 45-day identification period, it satisfies the identification requirement. Similarly, closing escrow on a replacement property prior to the 45-day identification deadline would also satisfy the property identification requirement.
Can you help me navigate the 1031 exchange process?
Yes, we can! The experts at 1031Gateway can connect you to 1031 professionals, education, and tools. Our team can also provide access to an extensive list of vetted on- and off-market replacement properties, including:
• Sole-ownership triple net properties
• Bank-owned properties
• Discounted real estate
• Fractional real estate interests (TIC or DST)
We can also help you find properties structured for a 721 exchange into a Real Estate Investment Trust (UPREIT).
How can I get started?
It’s easy! Just fill out the form at the top of the page to learn more today.
[1] “In the United States” in this case includes Washington D.C. and, in certain circumstances, the U.S. Virgin Islands, Guam, and the Northern Mariana Islands; it excludes other territories such as Puerto Rico, American Samoa, and the Minor Outlying Islands.
[2] Although securities are generally excluded, certain real estate structured for sale as securities do qualify for tax-deferred treatment in a 1031 exchange. Revenue Procedure 2002-22 lays out guidelines by which a Tenant-in-Common interest may qualify, and Revenue Ruling 2004-86 describes how an interest in a Delaware Statutory Trust may be acquired without recognition of gain under IRC section 1031.
[3] Since accepted LOIs qualify as property identifications, it is important not to invalidate one’s use of the 3-Property Rule by effectively “identifying” more than three properties, including any unrevoked property identifications submitted to the QI and separate LOIs.