Before the starker case, there weren’t so many rules guiding 1031 exchange, but because there was a difference of five years between the sales and the purchase of the replacement property in the starker case, these rules were introduced.
While these rules aren’t difficult to understand, they may ruin your exchange if you fail to follow them precisely.
1031 exchange, also known as a tax-deferred exchange, requires a taxpayer to identify a replacement property for the sold property within 45 days (identification period) or purchase it within 180 days (exchange period).
Please note that for a property to be qualified for a tax-deferred exchange, it must be an investment real property that you’ll exchange with another investment real property. Below are the identification rules in a 1031 exchange.
There are general rules guiding 1031 exchange that you must keep in mind. First, from the day the relinquished property closes, the taxpayer has 45 days to identify a replacement property. The taxpayer may have more than one specified property without regard to their price, but you’re not required to buy all.
Also, note that the taxpayer isn’t allowed to purchase a property that isn’t part of the identified properties. And once a replacement property is identified, you must buy it within 180 days.
A properly identified replacement property must include a legal description, street address, specific description, and name of the replacement property. If it’s a piece of raw real estate such as land under development, you must describe the ground in great detail and include as much information as possible about the improvements made on it.
The 45-day Identification Rule
The 45-day identification rule is straightforward. It requires the taxpayer to identify potential replacement property for the relinquished properties 45 days from the day they closed the sale of the first relinquished property. This period is also known as the identification period.
It doesn’t mean that you have to close the house within the 45-day identification period; you only need to have identified potential replacement properties before 45 days end.
Now, you can consider many replacement properties without regard to their cost, but you can only present a certain number at the end of the 45 day identification period. And, you need to list the properties in a written document signed by a qualified intermediary or take the title of the identified properties.
The properties that make it to the list are the only ones you can purchase once the 45-day identification period ends. While it may not seem like it, you may find it tough to identify replacement property within that period. My solid advice here is for you to start the process of identifying replacement property before the 45 days begin.
1031 Exchange 45-day Rule Extension
The delayed exchange where the exchange funds from the sold relinquished property are given to a qualified intermediary who uses it to purchase replacement property from a third-party seller is the more popular one.
A taxpayer must identify the replacement property within 45 days in a delayed exchange. The 45-day rule is so strict that it can only be extended on one condition. The condition is that the taxpayer is affected by federally declared disaster, terroristic, and military actions. Only then can the identification period be extended for up to 120 days.
Outside of a disaster, no one is exempted from the rule even if the 45th day turns out to be a legal holiday.
The Incidental Property Rule in Section 1031
Frequently, personal property like a laundry machine, dishwasher, etcetera, comes with the piece of real estate to be acquired. These are known as incidental properties. A property can only be considered incidental if it’s transferred together with the larger item of property and if its aggregate fair market value doesn’t exceed 15 percent of the aggregate fair market value of the larger property.
An incidental property doesn’t need to be identified separately, but when it comes to calculating gain, the multi-property 1031 exchange rule applies. This means that incidental property received with your replacement property will be taxable. Sometimes to the extent that a specific percentage from the 1031 deferred exchange funds will be used to pay for it.
The 3-property Rule
The three-property rule permits a taxpayer to identify up to three potential properties for replacement before the end of the identification period. The prospective replacement properties must be of equal or greater total value to your just relinquished property.
Though you can list up to three properties as replacement properties, you’re not obliged to buy them all, and you are under no obligation to purchase the first identified property either. You can change the identified replacement properties on your list as many times as you wish. But identification rules insist that your list of properly identified property (ties) must be ready before the end of the 45 days.
What if you want to identify more than three properties? You can but, the 3-property rule will not apply here. You can identify any number of replacement properties as long as the total fair market value doesn’t exceed 200% of the combined fair market value of relinquished properties.
The 95 percent rule isn’t prevalent because while it allows you to identify more than three replacement properties, you have to purchase all of them. The fair market value rule doesn’t apply here.
The aggregate fair market value of the properties to be acquired has to exceed 200 percent of the fair market value of relinquished properties. So while identifying as many replacement properties as you deem fit, also prepare to buy them all.
While the 45 day identification period states the number of days for identifying replacement property from the day when a taxpayer transfers the relinquished property, the 180-day rule, also known as the exchange period in 1031 exchange identification, states the timeframe for acquiring new replacement properties.
By the end of the identification period, the taxpayer has to acquire replacement property within 180 days. The replacement properties acquired within this exchange period are properties considered properly identified.
Generally, the qualified intermediary is the person who facilitates a 1031 exchange. They hold the money from the relinquished property and purchase a new replacement property. An intermediary can’t be any person involved directly in the taxpayer’s business or a disqualified person.
Knowing and following 1031 exchange identification rules will make for seamless exchange transactions. Engaging the services of legal advisors and a real estate agent to help with exchange services is also superb.
Remember that a written document with a legal description of properties identified before the end of the identification period is what qualifies a property for a 1031 exchange. All previous identification not included in the document doesn’t count.
It’s possible for a lawyer to perform the exchange services for you but not necessary just as long as a qualified intermediary is involved in the exchange.