1031 Exchange Guidelines for Identifying Replacement Properties in a “Delayed Exchange”
In a prior article, I discussed the requirements of Internal Revenue Code § 1031 (“IRC 1031”) which allow an investor to defer payment of capital gains tax (“CGT”) on the sale of real property by reinvesting the sale proceeds in other real property (“1031 Exchange”). Therein, I described a type of 1031 Exchange known as a “delayed exchange”, which occurs when the exchanger sells the relinquished property on one date and then purchases “like-kind” replacement property within a 180 day period thereafter.
How delayed exchanges work
As shown, in a “delayed exchange”, a Qualified Intermediary (“QI”) holds the net proceeds from the sale of the relinquished property and releases those funds to complete the purchase of the replacement properties. To comply with IRC 1031, the investor must identify the replacement properties within 45 days from the closing of the relinquished property. This is usually accomplished by the investor sending an unambiguous signed writing to the QI setting forth the address and block and lot designations of replacement properties expected to be purchased. Investors often worry about losing the tax benefit of a 1031 Exchange if for some reason he/she is not able to close on the identified replacement properties within the 180 day period.
Qualifying for deferment of CGT
Fortunately for the investor, IRC 1031 permits identification of multiple potential replacement properties, valued in excess of the proceeds from the sale of the relinquished property. However, this over-identification is limited by statutory rules.
The investor must comply with at least one of the following three rules to qualify for deferment of CGT:
- Three Property Rule: For each relinquished property, the taxpayer may identify up to three replacement properties without regard to their fair market value; or
- Two Hundred Percent Rule: The exchanger may identify any number of replacement properties if their combined fair market value does not exceed 200% of the fair market value of the relinquished properties; or
- Ninety Five Percent Rule: The investor may identify any number of replacement properties without regard to their aggregate fair market value provided the replacement properties ultimately purchased total at least 95% of the fair market value of all identified properties.
If the taxpayer fails to strictly comply with at least one of these identification rules, the entire 1031 Exchange transaction will be disallowed.