In order to successfully defer capital gains taxes using a 1031 exchange, an investor must identify potential replacement properties, in writing, by midnight of the 45th calendar day after the close of escrow on the relinquished property. If the IRS requirements concerning property identification and receipt are not met, the transaction will be recognized as a taxable sale rather than a tax-deferred exchange. Here is what you need to know.
Property Identification Rules
Rule #1: Only Identify Properties of Like Kind
Only potential replacement properties of like kind may be identified for use in a 1031 exchange. Generally, real properties in the United States held for investment or business purposes are considered to be like kind to one another, regardless of their grade or asset class.
- Real Property vs. Personal Property
Real property and personal property can be exchanged without recognition of gain under IRC section 1031. However real property is not like kind to personal property and vice versa. Real property can only be exchanged for real property, and personal property can only be exchanged for personal property.
- Domestic Property vs. Foreign Property
Only property located in the United States and certain U.S. territories may be exchanged without recognition of gain under IRC section 1031. Property in the United States is not considered like kind to property outside the United States and vice versa.
- Residential and Commercial Property May Be Exchanged
Residential property held for investment (such as rental property) may be exchanged for commercial property and vice versa. However, note that a taxpayer’s personal residence or vacation home may not be exchanged for investment real estate of any kind under IRC section 1031, because it is not held for investment or business purposes. (However, there are other tax shelters for the proceeds of the sale of personal residences.)
- Unimproved and Improved Property May Be Exchanged
Raw land may be exchanged for improved real estate and vice versa.
- Land Conveyed Without Its Property and Land Conveyed With Its Property May Be Exchanged
Land that is conveyed without its improvements (ground lease ownership) and land conveyed with its improvements (fee simple ownership) are like kind and may be exchanged.
- Property Conveyed Without Its Land Has Special Rules
Property improvements conveyed without land (leasehold interest) do not always qualify. Specifically, a leasehold interest must have a ground lease with at least 30 years remaining (including renewal options) to qualify for 1031 exchange. A leasehold interest with fewer than 30 years remaining does not qualify for like kind exchange.
- Specific Exclusions
Finally, certain types of property are specifically excluded tax-deferred treatment under IRC Section 1031. Section 1031 does not apply to exchanges of:
Rule #2: Only Identify Property Held for Business or Investment Purposes
Only property that will be held for productive use in a trade or business or for investment qualifies for use in a 1031 tax-deferred exchange. Therefore it is crucial for an investor to identify property intended for business or investment.
If a replacement property will be held with the intent to be used productively in a trade or business or investment and yet it turns out to be unproductive, it will not nullify the 1031 exchange.
- Predominant Use
If one will occasionally rent out a property that will otherwise be used as one’s personal residence or vacation home, or if one intends to operate a home office in a property, such does not qualify as a replacement property in a 1031 exchange, because the predominant use of such property would not be for investment or business purposes.
Conversely, if one will occasionally use a rental property for personal purposes, it may nevertheless be used as a replacement property in a 1031 exchange. It is important that the Safe Harbor limits below are adhered to, however, to ensure proper consideration of a property’s status for 1031 exchange purposes.
- Safe Harbor
Revenue Procedure 2008-16 specifies conditions under which the IRS will not challenge one’s intent to hold a replacement property for business or investment purposes.
- …a property is held for two years or more, and
- during each of the two years after the exchange it is rented out for 14 days or more, and
- during each of the two years after the exchange it is not used for personal purposes for any more than 14 days or 10% of the duration for which it is rented out…
…then its intent to be held for investment purposes will not be challenged by the IRS.
Rule #3: Use EITHER the 3-Property Rule, the 200% Rule, OR the 95% Rule
- 3-Property Rule
An investor may identify up to three potential replacement properties, regardless of the aggregate market value of the properties, and acquire as many of the propertiesidentified as desired to complete the exchange.
- 200% Rule
An investor may optionally identify more than three potential replacement properties, if their aggregate market value does not exceed 200% of the market value of the relinquished property. An investor may acquire as many of the properties identified using the 200% Rule as desired to complete the exchange.
- 95% Rule
An investor may optionally identify any number of potential replacement properties, regardless of their aggregate market value, if the investor acquires 95% of the aggregate market value of all the properties identified using the 95% Rule.
Complying with one of these identification rules requires advanced planning, and failing to comply results in the taxable recognition of capital gain. Potential replacement property identifications may be revoked prior to the identification deadline, however once midnight on the 45th calendar day after the close of escrow on the relinquished property elapses, unrevoked property identifications cannot be changed. This may commit an investor to acquiring property that might not otherwise be desired in order to comply with the rules and successfully avoid the capital gains taxes.
Rule #4: Identify Potential Replacement Properties by the 45th Day
The identification period is exactly 45 calendar days long. The first day after the close of escrow is day #1. The replacement property identification must take place by midnight on day #45. If this day falls on a weekend or holiday, the deadline is not extended. Exceptions may be declared only by the President of the Unites States, which may be done on extremely rare occasions, such as natural disasters, that affect the properties or parties involved with the 1031 exchange process.
[Use our 1031 Time Limit Calculator.]
How to Submit Your 1031 Replacement Property Identification
IRC section 1031 requires property identifications to be “hand delivered, mailed, telecopied, or ‘otherwise sent.’” Property identifications today are typically emailed, and recipients reply by email, with the property identifications attached to the reply, to confirm receipt.
Property identifications must be submitted to an involved party. The standard practice today is to submit property identifications to one’s Qualified Intermediary, who will be party to the official Exchange Agreement and therefore demonstrably “involved” in the exchange.
Other examples given by the IRS of “involved” parties include the person obligated to transfer the replacement property to the taxpayer (which can be different from the Qualified Intermediary in certain circumstances), any party to the exchange, an escrow agent, and a title company.
IRS Fact Sheet 2008-18 specifically disqualifies one’s attorney, real estate agent, accountant, or similar persons who act as one’s agent from receiving one’s 1031 replacement property identifications.
What to Include
Most QIs have standardized paperwork and years of experience to help facilitate this process. However, at minimum, property identifications must include specific, unambiguous descriptions of each property. This may include legal descriptions, street addresses, Assessors Parcel Numbers, and any recognized building names.
If one is using the 200% rule and planning to acquire a fractional interest, such as a Tenant-in-Common or Delaware Statutory Trust interest, one ought to specify the percentage or dollar amount being considered for acquisition. Failing to do so may be interpreted as an identification of the entire property. Such may result in the total market value of one’s property identifications being greater than 200% of the value of one’s relinquished property, which could trigger a taxable event.
Alternative 1031 Property Identification Methods
If a Letter of Intent (LOI) or contract is signed by its parties prior to the end of the 45-day identification period, it satisfies the identification requirement. Similarly, closing escrow on a replacement property prior to the 45-day identification deadline would also satisfy the property identification requirement.
Let Us Help
If you are considering a 1031 exchange call ExchangeRight today for access to in-depth information about our net-leased portfolios, which are structured to qualify as replacement property for 1031 and 1033 exchanges.
 “In the United States” in this case includes Washington D.C. and, in certain circumstances, the U.S. Virgin Islands, Guam, and the Northern Mariana Islands; it excludes other territories such as Puerto Rico, American Samoa, and the Minor Outlying Islands.
 Although securities are generally excluded, certain real estate structured for sale as securities do qualify for tax-deferred treatment in a 1031 exchange. Revenue Procedure 2002-22 lays out guidelines by which a Tenant-in-Common interest may qualify, and Revenue Ruling 2004-86 describes how an interest in a Delaware Statutory Trust may be acquired without recognition of gain under IRC section 1031.
 Since accepted LOIs qualify as property identifications, it is important not to invalidate one’s use of the 3-Property Rule by effectively “identifying” more than three properties, including any unrevoked property identifications submitted to the QI and separate LOIs.