Over the last week or so I have been having a running dialogue with Michael Lindekugel of Team Reba – RE/MAX Metro Realty, Inc. about general 1031 exchange principles on the Rain City Guide. To continue that conversation about identifying replacement 1031 properties, I decided to post here about how to identify replacement properties. Tomorrow I will talk more about the challenges to identifying 1031 replacement properties and some ways to fix the potential identification problems. Sorry to Eileen Tefft for being a little late on the post.
The Identification Rules
When doing a 1031 exchange one of the greatest challenges we have seen is our clients do not often understand how to properly identify appropriate properties within the 45-day time deadline.
No matter which of the three identification rules is followed, the properties must be identified and submitted to the client’s Qualified Intermediary before midnight on the 45th day after the closing date of the first sold property.
Three Property Rule – The norm
The first identification rule is to identify three (3) properties of any value within the 45-day time period. The bulk of exchangers will follow this first rule.
200% Rule – Used sparingly
Michael stated the second rule well in our earlier conversations:
“The exchanger identifies any number of properties as long as the aggregate FMV is less than or equal to 200% of the aggregate fair market value of all disposed properties.”
For example, if I sold $500k worth of properties, I could identify an infinite amount of properties so long as their aggregate FMV did not exceed $1 million (200% of the aggregate relinquished FMV). This rule is used sparingly as most people keep their options to less than three properties as they have a goal in mind of where they want to be and how much they want to spend. This second rule is useful though for especially hot markets where a property you identified has the potential to be sold before you can purchase it.
95% Rule – Used very rarely
The third rule states that an exchanger can identify as many properties as they wish for whatever aggregate value, so long as they close on 95% of the properties they identified. This does not mean that you purchase 95% worth of the aggregate FMV that was identified, it means that you must close on every 19 of 20 houses you identify. It’s a very stringent rule that seems unrealistic, but some people – especially big-time investors – will be exchanging this many properties at once. The more realistic application of this rule exists in the example below.
Suppose you want to identify and purchase 5 properties but their aggregate FMV is over 200% of the sold properties’ FMV. This would vitiate the 3 Property Rule and the 200% Rule. So, if you are certain you will close on all 5 then you will want to follow this rule as closing on all 5 means that you will close on 100% of your identified properties.
But what if you only close on 4 of the properties? That means you have purchased only 80% of your properties, and because you used the 95% Rule for identifying your properties, your whole exchange is null and void. Taxes will be due and the government looks at it as if no exchange took place.
This rule is very cumbersome and generally only used by large investors who have great trust that they will be able to get nearly all of their properties. But, it can be used on a smaller scale too, as evidenced in our example.
Now that we know the rules, tomorrow we’ll discuss the challenges that identification of replacement properties brings and how to fix these challenges before they actually become challenges.