Understanding property identification under IRC Section 1031 and what to do when you wish to identify more than three replacement properties.
Section 1031 like-kind exchanges are governed by many rules, and violating those rules can result in a property sale being subject to taxation, negating the potential tax deferral benefits of an exchange. In a forward exchange, potential replacement properties must be identified according to a specific procedure and timeline. While many exchangers imagine they will only need to identify a single replacement property, there are many reasons to find multiple options. In this blog, we’ll explore some of those reasons and how to diversify property holdings through something known as the 200% rule.
1031 exchange property identification rules
When carrying out a forward exchange, the exchanger has 45 days after the closing date of the relinquished property sale to identify a replacement property according to proper 1031 procedures. The taxpayer then has until Day 180 to acquire the identified replacement property. But what if your first choice of replacement property falls through? That’s where the three-property rule comes in.
According to the three-property rule, an exchanger can identify up to three replacement properties, regardless of their individual or aggregate fair market value. Once you identify your chosen properties, you can acquire any number of them, so long as the property you acquire is among those identified. This allows exchangers to have backup options in case one falls through. Many experts recommend using all three identification slots just in case, and many exchangers choose a Delaware Statutory Trust as one of their identified properties to provide a backstop.
Limiting the number of properties that an exchanger can identify is necessary to keep things from getting out of hand: if there were no limits of any kind, an exchanger could identify every property within a large geographical area, defeating the purpose of identification.
The three-property rule works for those who wish to acquire a replacement property valued at around the same amount as their relinquished property or one that is more valuable, but what about if you want to diversify into several properties of lower value than your relinquished property? If you wish to acquire more than three properties, the three-property rule would no longer be adequate. That’s why there are additional rules to cover these scenarios.
How does the Section 1031 200% rule work?
As stated in the Internal Revenue Code (§ 1.1031(k)–1), the maximum number of properties that can be identified under the 200% rule is “Any number of properties as long as their aggregate fair market value as of the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties as of the date the relinquished properties were transferred by the taxpayer.”
The best way to understand the 200% rule is to understand the situations where it is intended to be used and situations where it is not. Let’s imagine your relinquished property has a fair market value of $1 million. You find four potential replacement properties, each of which has a fair market value of $1 million or more. In this case, the 200% rule cannot be used because any single one of your replacement properties could achieve full tax deferral in an exchange. The three-property rule is meant for that scenario.
The 200% rule is for scenarios in which the acquisition of multiple properties could be required to achieve total tax deferral. Let’s say your relinquished property is yet again valued at $1 million. This time, your plan is to acquire multiple smaller properties, each valued at $400,000. If you identified three of them according to the three-property rule, you’d need to acquire all three to achieve total tax deferral, meaning that under the three-property rule, you’d have no backup options.
In cases like this, the 200% rule allows the taxpayer to identify additional properties to provide the same backstop that exists for those identifying properties valued the same or greater than their relinquished properties. The 200% rule ensures you aren’t punished for diversifying with a series of lower-value property investments.
In the scenario with the $1 million relinquished property, you could identify any number of properties of any individual value so long as the total aggregate value of the identified properties does not exceed $2 million (200% of $1 million). That could be five $400,000 properties or 40 $50,000 properties. You could also identify one $1 million property and ten $100,000 properties, only to ultimately acquire the $1 million property – the 200% rule allows for the possibility of diversification, but doesn’t require it.
The 200% rule is useful for those who wish to fill their backup slots with interests in Delaware Statutory Trusts. Many DSTs have a minimum investment of $100,000, so under the 200% rule, an exchanger could spread their investment across a series of DSTs. Without the 200% rule, the exchanger might be forced to invest all $1 million in a single DST, limiting the diversification of their portfolio. Because the 200% rule exists, the backup option of a DST becomes even more attractive.
Requirements for qualifying under the 200% rule
To qualify under the 200% rule, the timeline and reporting requirements for a forward exchange still apply. The exchanger has 45 days from the date the relinquished property is sold to identify replacement properties in writing to all parties involved in the exchange. A property acquired before the 45-day deadline is considered to be identified.
The most important aspect of the 200% rule is that the math must be correct. If your relinquished property was valued at $1 million and the values of your identified properties add up to $2.1 million, you’ll be in violation of the 200% rule. And properties must be accurately valued: if you identify a property as being valued at $800,000 and eventually acquire it at $1 million, this may get noticed and be considered a violation.
Setting yourself up for success with JTC
The 200% rule is just one of many rules governing Section 1031 like-kind exchanges. Every exchange is different, and performing an exchange that involves a less-common scenario requires the experience of seasoned professionals.
JTC specializes in exchanges that follow complex procedures such as reverse exchanges and those involving Delaware Statutory Trusts. If you’re considering a series of DSTs as a replacement property and want to pursue an exchange under the 200% rule, select a Qualified Intermediary that has the experience and knowledge necessary to help you carry it out.
To learn more about JTC’s 1031 Qualified Intermediary services,
