Following the identification rules and necessary identification step in a 1031 exchange is important. Below are the basic 1031 law and various rules from the 1031 regulations that should be followed to properly identify replacement property in a 1031 exchange.
The IRC Section 1031 Identification Requirement
The law IRC Section 1031(a)(3) states:
“ … any property received by the taxpayer shall be treated as property which is not like-kind property if:
a. such property is not identified as property to be received in the exchange on or before the day, which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or
b. such property is received after the earlier of
(i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or
(ii) the due date (determined with regard to extension) for the transferor’s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.”
Since the basic law did not limit the number of properties that could be identified, some taxpayers provided multiple identifications, like an MLS listing book. The IRS felt there had to be a limit on the number of properties or value that could be identified. Thus the IRS Regulation Section 1.1031(k)-1 was published to include establishment of rules for the identification method and to control the number of replacement properties identified.
Identification Period and Exchange Period.
Following the basic 1031 law the IRS Regulation 1.1031(k) -1(b)(2) clearly establishes the ID period and Exchange Periods as follows:
“(i) The identification period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the 45th day thereafter.
(ii) The exchange period begins on the date the taxpayer transfers the relinquished property and ends at midnight on the earlier of the 180th day thereafter or the due date (including extensions) for the taxpayer’s return of the tax imposed by chapter 1 of subtitle A of the Code for the taxable year in which the transfer of the relinquished property occurs.”
When necessary, an extension request should be submitted on time.
If, as part of the same deferred exchange, the taxpayer transfers more than one relinquished property on different dates, the identification period and the exchange period are determined by reference to the date on which the first property is transferred. The property is considered transferred when the property is disposed of within the meaning of basic IRC Section 1001(a).
Manner for Identifying Replacement Property
The regulation also established the manner for identifying replacement property. It must be designated as replacement property in a written document signed by the taxpayer and be received before the end of the ID period by either –
a. the person obligated to transfer the replacement property to the taxpayer, even if a disqualified person; or
b. any other person involved in the exchange other than the taxpayer or disqualified person.
Note that most exchange agreements require the identification (ID) notification be sent on time to the involved Qualified Intermediary (QI).
The identification must be signed by the taxpayer, and not the agent or someone else.
Any replacement property that is received before the end of the 45 day ID period will be treated as identified.
A replacement property identified in a written agreement for the exchange of the properties, and signed by all parties thereto, before the end of the 45 day identification period will satisfy the identification requirements.
Description of Replacement Property
Replacement property must be identified in an “unambiguously” described manner in a written document or agreement. Real property (real estate) is generally described by a legal description (for example, how it is described in the deed), street address (123 Main St, Exampletown, St, 00000), or distinguishable name (King Ranch, Kingsville, Texas).
One point that often comes up is how to identify Delaware Statutory Trusts (DST) as replacement property, as our clients often use these assets as replacements. Some of our clients have identified these properties by identifying the portion of the DST “which owns XYZ propert(ies)”
For Example: “2% of Example DST which owns 123 Main Street, Exampletown, ST, 00000”
At this time the IRS has not published clear guidelines for identifying DST properties for 1031 exchanges.
Alternate and Multiple Properties
The Regulation Section 1.1031(k)-1(c)(4) provides the rules which permit the taxpayer to ID more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, there are three separate rules that a taxpayer may use to identify properties:
The three property rule: This is the rule most often followed by exchangers. It simply means a taxpayer can identify a maximum of three like-kind properties of any fair market value (regardless of the value of the relinquished property).
The 200% Rule: If an exchanger wishes to identify more than three properties, the total market value of the replacement properties identified must not be greater than 200% of the relinquished property.
The 95% Rule: If the exchanger wishes to identify more than 3 properties AND they wish to exceed 200% of the value of their relinquished property on their identification, they must purchase 95% of the total value of the properties identified.
Click here to read the regulation
“(i) The taxpayer may identify more than one replacement property. Regardless of the number of relinquished properties transferred by the taxpayer as part of the same deferred exchange, the maximum number of replacement properties that the taxpayer may identify is:
(A) Three properties without regard to the fair market value of the properties (the “3-property rule”), or
(B) 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 “200 percent rule”).
(ii) If, as of the end of the identification period, the taxpayer has identified more properties as replacement properties than permitted by paragraph (c)(4)(i) of this section, the taxpayer is treated as if no replacement property had been identified …”
The important exceptions to the above are that any replacement property received by the taxpayer before the end of the identification period will be treated as identified, and as stated in the regulation “any replacement property identified before the end of the identification period and received before the end of the exchange period, but only if the taxpayer receives before the end of the exchange period identified replacement property the fair market value of which is at least 95 percent of the aggregate fair market value of all identified replacement properties (the “95-percent rule”).
The fair market value of each identified replacement property is determined as of the earlier of the date the property is received by the taxpayer or the last day of the exchange period.
(iii) For purposes of applying the 3-property rule, the 200- percent rule, and the 95-percent rule, all identifications of replacement property, other than identifications of replacement property that have been revoked, are taken into account. For example, if, in a deferred exchange, B transfers property X with a fair market value of $100,000 to C and B receives like-kind property Y with a fair market value of $50,000 before the end of the identification period, property Y is treated as identified by reason of being received before the end of the identification period. Thus, B may identify either two additional replacement properties of any fair market value or any number of additional replacement properties as long as the aggregate fair market value of the additional replacement properties does not exceed $150,000.
Only Property Identified May be Purchased
After the 45-day ID period only those properties identified may be purchased as replacement properties and be part of the exchange. No new properties may be identified after the 45-day identification period. Unfortunately, the law and regulations do not give any relief for a situation where all of the identified properties become unavailable after the identification period has passed. If you have identified and are unable or unwilling to purchase what has been identified to us, we are obligated to hold your funds until the end of the 180 day deadline to purchase.
Revoking the Identification.
A replacement property identification may be revoked at any time before the end of the identification period. The ID is revoked only if the revocation is made in a written document signed by the taxpayer and sent before the end of the identification period to the person to whom the identification of the replacement property was sent.
Incidental Property Disregarded.
Property that is incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if in standard commercial transactions, the property is typically transferred together with the larger item of property, and the aggregate fair market value of all of the incidental property does not exceed 15 percent of the aggregate fair market value of the larger item of property.
Identification of Property to Be Built
The regulations provide special rules for the identification and receipt of replacement property to be built. The identification requirement for the property to be built will be met if the identification provides “a legal description for the underlying land and as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made.”
Note: Improvements to be made to property already owned by the exchanger are not considered like-kind and cannot be used as a replacement property.