How to Identify Replacement Property
The Exchanger has 45 days from the date of the sale of the relinquished property to identify the potential replacement properties. The identification is a written letter or form which is signed and dated by the taxpayer, and contains an unambiguous description of the replacement property. A property which is identified is not required to be under contract or in escrow to qualify. Exchangers acquiring an undivided percentage interest (“fractional interest”) in a property should identify the specific percentage that will be acquired. If the subject exchange is an improvement exchange the Exchanger must specifically identify the improvements to be made to the real property as part of the exchange.
The Exchanger may change the properties identified as often as it wants during the 45 day identification period by revoking the previously identified properties and then identifying new potential replacement properties. It is essential that the identification is delivered by midnight of the 45th day, or postmarked by the 45th day, to the Exchanger’s Qualified Intermediary or to a party related to the exchange who is not a disqualified person. Typically, delivering the identification to the Qualified Intermediary is the safest course of action to prevent disqualification of the transaction for an invalid or untimely identification. If the Exchanger fails to deliver the identification in a timely fashion, or does not comply with one of the three identification options, the exchange may be disallowed.
There are restrictions on the number or value of the properties an exchanger identifies. To qualify for a 1031 exchange, the exchanger must comply with one of the following identification options:
1) The Three Property Rule allows an Exchanger to identify up to three replacement properties. There is no value limitation placed upon the prospective replacement properties and the exchanger can acquire one or more of the three properties as part of the exchange transaction. The “three property” rule is the most commonly used identification option, allowing an exchanger to identify fall back properties in the event the preferred replacement property can not be acquired. Typically, this rule is used by exchangers who want to purchase one, perhaps two, replacement properties in order to complete their exchange.
2) The 200% Rule allows an Exchanger to identify an unlimited number of properties, provided that the total value of the properties identified does not exceed 200% of the value of all relinquished properties. There is no limitation on the total number of potential replacement properties identified under this rule, only a limitation on the total fair market value of the identified properties. Typically, this rule is used by exchangers who are looking to diversify and buy several properties which individually are much smaller in value than the relinquished property, but in total are equal to or exceed the value of the relinquished property.
For example, if an Exchanger sold relinquished property for $1,000,000 under the 200% rule, the Exchanger would be able to identify as many replacement properties as desired, provided the aggregate fair market value of all of the identified properties does not exceed $2,000,000 (200% of the $1,000,000 sales price of the relinquished property).
3) The 95% Exception Rule allows an Exchanger to identify an unlimited number of replacement properties exceeding the 200% of fair market value rule, however the Exchanger must acquire at least 95% of the fair market value of the properties identified. This rule is utilized in limited circumstances as there is a much higher risk of the transaction failing. The 95% Exception Rule also creates a risk because if the Exchanger does not acquire 95% of the fair market value of all identified properties the entire exchange fails.
For example, assume an Exchanger identifies ten properties of equal value. In order to satisfy the rule, the Exchanger would be required to acquire all ten identified properties within the exchange period to complete a successful exchange. If one of the properties fell through, the entire 1031 exchange would be disqualified because the exchanger did not acquire 95% of the fair market value identified. This rule should only be utilized in situations where there is a high level of certainty pertaining to the acquisition of the identified properties and the other two rules do not meet the Exchanger’s objectives.
Legal 1031 Exchanges Services, Inc. provides each of its exchangers with a property identification form as part of our standard set of exchange documents.