There are strict guidelines for locating and acquiring potential like-kind replacement properties in a 1031 exchange transaction. To defer capital gains taxes by a 1031 exchange, investors must identify candidate replacement properties within 45 days, according to Section 1031 of the Internal Revenue Code (“IRC”).
- Investors may need help identifying their replacement property within 45 days of selling their relinquished property.
- As a result, the IRC allows investors to identify numerous potential replacement properties.
Here is an explanation of the three identification rules and an explanation of why you might choose one strategy over another.
What is the Three Property Identification Rule
The Three Property Identification Rule is a rule used in the United States to determine the tax consequences of a 1031 exchange, also known as a “like-kind exchange.” The 1031 exchange is a transaction where an investor can defer paying taxes on the sale of a property by using the proceeds to purchase a similar property.
The Three Property Identification Rule states that an investor can identify up to three potential replacement properties, regardless of their fair market value, as long as they are acquired within 45 days of the sale of the original property. The investor must then acquire at least one of these properties within 180 days of the sale of the original property.
For example, an investor sells a rental property for $500,000 and wants to use the proceeds to acquire a replacement property through a 1031 exchange. The investor identifies three potential replacement properties:
- A commercial building for $450,000
- A rental property for $600,000
- A land for $300,000
The investor has 45 days from the original property’s sale date to identify the replacement properties and 180 days from the date of sale of the original property to acquire one of the replacement properties.
It’s important to note that the sold property and replacement property must be considered “like-kind,” meaning they must be similar in nature or use. And also, the investor needs to follow all the other rules and regulations of 1031 exchange and tax laws.
What is the 200% of Fair Market Value Identification Rule
The 200% Fair Market Value Identification Rule is a rule in the 1031 exchange process that allows investors to identify up to twice the fair market value of their relinquished property when identifying potential replacement properties. This means that an investor can identify multiple properties as long as their total fair market value does not exceed 200% of the fair market value of the relinquished property. This rule is designed to give investors more flexibility and options when identifying replacement properties for their 1031 exchange.
For example, let’s say a taxpayer purchased a piece of land for $50,000 and then donated it to a charitable organization. The fair market value of the land at the time of the donation is $100,000. The taxpayer’s adjusted basis in the land is $50,000. Under the 200% of Fair Market Value Identification Rule, the taxpayer would be able to deduct $50,000 (200% of the adjusted basis) as a charitable contribution, even though the fair market value of the land is $100,000.
What is the 95% Identification Exception?
The 95% Identification Exception of a 1031 exchange, also known as the “95% rule,” is a guideline set forth by the Internal Revenue Service (IRS) that allows for a slightly more relaxed approach to identifying potential replacement properties in a 1031 exchange.
In a traditional 1031 exchange, taxpayers must identify potential replacement properties within 45 days of the sale of the relinquished property and close on the replacement property within 180 days. The identification must be specific, and the taxpayer must acquire the identified properties.
The 95% Identification Exception allows taxpayers to identify up to three potential replacement properties without regard to the fair market value. Additionally, taxpayers can identify an unlimited number of potential replacement properties as long as the aggregate fair market value of the identified properties does not exceed 95% of the aggregate fair market value of all potential replacement properties.
This exception allows taxpayers more flexibility in identifying replacement properties, as they don’t need to worry about being locked into a specific property within the 45-day identification period. It also allows taxpayers to identify a larger pool of potential replacement properties, increasing the chances of finding a suitable replacement property.
However, it’s important to note that the 95% Identification Exception is not mandatory, and taxpayers can still choose to use the traditional identification method if they prefer.
Did You Know?
- The replacement property must be “like-kind” to the property being sold. This means that the replacement property must be of the same nature or character as the property being sold, even if it is of a different grade or quality.
- The replacement property must be of equal or greater value than the property being sold. Additionally, any debt assumed on the replacement property must be equal to or greater than the debt on the relinquished property.
How to Identify Replacement Properties
In a 1031 exchange, replacement properties are acquired with the proceeds from selling the relinquished property. To identify the replacement properties, the following steps can be taken:
- Determine the type of property sold (the relinquished property) and the type acquired (the replacement property).
- Identify potential replacement properties within the required time frame (45 days from the date of sale of the relinquished property).
- Provide the qualified intermediary with a written description of the replacement properties.
- Close on the replacement property within 180 days of the sale of the relinquished property.
It’s important to note that the replacement property and the relinquished property must be of “like-kind,” meaning they must be used for the same purpose (investment or business) and be of similar nature or character. Additionally, the Tax code set some limitations and restrictions to the 1031 exchange; it’s recommended to consult with a tax professional before proceeding with any 1031 exchange.
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