Guest Column: A Guide to Section 1031 Exchanges (Part One)
Tip No. 1: Do not identify replacement property
By Louis Rogers, Founder and CEO of Capital Square 1031, LLC
Louis Rogers is founder and chief executive officer of Capital Square 1031, LLC, a sponsor of replacement property for Section 1031 exchanges. Rogers has authored a series of tips for investors seeking to participate in Section 1031 exchanges. In the first of this series, Rogers discusses the risks associated with the requirement to “identify” replacement property and suggests that exchangers close on all replacement property within 45 days to eliminate the identification requirement.
Whenever possible, avoid the risk and hassles of exchange identification by closing all replacement property within 45 days of closing the relinquished property. This can be readily accomplished with careful planning.
Simultaneous vs Non-Simultaneous Exchanges. In a simultaneous exchange, the exchanger transfers the relinquished property and acquires the replacement property at the same time. Both legs of the exchange occur simultaneously. In a non-simultaneous exchange, sometimes referred to as a “delayed” exchange, the exchanger transfers the relinquished property and acquires the replacement property at a later date. This can be very helpful to exchangers who need additional time to acquire their replacement property. In modern times, almost all exchanges are non-simultaneous or delayed.
Section 1031 of the Internal Revenue Code was amended in 1984 to permit non-simultaneous exchanges. The amendments imposed the 45-day identification requirement and the 180-day exchange period described below. Many exchangers struggle with the 45-day identification requirement.
45-Day Identification Requirement. Section 1031(a)(3)(A) provides that any property received by the taxpayer will not qualify for exchange treatment if:
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.
This is commonly referred to as the 45-day identification requirement. Many exchangers struggle with the 45-day identification requirement.
180-Day Exchange Period. Section 1031(a)(3)(B) provides that the taxpayer must close on all replacement property within the earlier of (i) 180 days of closing the relinquished property or (ii) the due date of the taxpayer’s tax return in question (with extensions). This is commonly referred to as the 180-day exchange period. Exchangers who need more than 180 days from transfer of the relinquished property to acquire all replacement property may extend the due date of their tax return to obtain additional time. Hence, exchangers rarely struggle with the 180-day exchange period.
The IRS has been proactive over the years in issuing helpful guidance on Section 1031. Back in 1991, the IRS issued regulations on non-simultaneous exchanges. The Regulations permit taxpayers to identify three or more (multiple) replacement properties and choose at a later date which property or properties to acquire as the actual replacement property. In this way, exchangers can play the market for 45 or more
days. This can be very helpful to exchangers who need additional time, for example, to conduct due diligence, resolve property-specific issues, or complete their financing. Exchangers may pick and choose from property on the list of properly identified properties; they can acquire any one, two, three or all of the identified properties as their actual replacement property, provided the property in question was properly identified.
The regulations also created a “safe harbor” permitting qualified intermediaries or accommodators to hold exchange proceeds for exchangers. Intermediaries perform a vital role in the exchange process by holding exchange proceeds and typically serving as the recipient of ID notices. More to follow on intermediaries in a later Tip.
Multiple Property Identification. The Regulations established three rules that can be used to identify multiple replacement property in a non-simultaneous exchange. One ID rule is very simple (the three property rule), one can be complex (the 200 percent rule), and one is rarely used (the 95 percent exception).
The Regulations permit taxpayers to identify multiple replacement properties and decide later which of the identified properties to acquire in the exchange. To qualify, all replacement property must be acquired during the 180-day exchange period.
Multiple property identification is beneficial to exchangers who do not have all their replacement property lined up when the relinquished property is transferred. However, there is a risk to exchangers who ID multiple replacement property – even a minor error in over identifying will render the entire exchange fully taxable. The solution is to acquire all replacement property within the 45-day period, so the taxpayer is not required to ID.
Delayed Exchange Identification Options. Exchangers can use one of the following options to identify multiple potential replacement property:
Three Property Rule – three properties of any value. This is the simplest ID rule; if you can count to three, you can use this rule. But be careful—it is not always obvious what constitutes a single “property” for this purpose.
200 Percent Rule – 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 they were transferred by the taxpayer. This can be a complex ID rule to apply because it requires computation of fair market value on properties that have not yet been acquired.
95 Percent Exception – any number of properties, 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. This long-winded ID rule is infrequently used due to the 95 percent of value acquisition requirement.
ID Challenges in the Real World. The ID rules can be difficult to apply in real world situations. Over time, some exchangers have incorrectly computed or simply missed the 45-day deadline. For example, the date shown on the settlement statement for the relinquished property transfer may not be the actual date of
closing for tax purposes. If the actual closing date is later, it is possible to inadvertently miss the 45-day deadline, rendering the proposed exchange fully taxable.
Many exchangers struggle making the 45-day computation. To summarize: the day of closing on the relinquished property is Day 0 (the next day is Day 1); count 45 calendar days, including weekends and holidays; and there are no exceptions, barring a Presidentially-declared national disaster or a terroristic or military action. By midnight of the 45th day, computed in this manner, the exchanger must send the ID notice to the qualified intermediary.
Even the simplest ID rule, the three property rule, has its challenges because it is not always obvious to exchangers what constitutes a single “property” for ID purposes. In this way, exchangers may inadvertently ID more than three properties.
Value can be difficult to determine under the 200 percent rule. How does a taxpayer know the fair market value of a property he or she would like to acquire but has not yet acquired? And it may not be possible for the exchanger to actually acquire 95 percent of the aggregate fair market value of the identified properties to qualify for the 95 percent exception.
Bottom line: exchangers who (i) ID more than three properties, (ii) ID more than 200 percent in value, or (iii) fail to acquire 95 percent or more in value of the properties identified, will have failed to identify properly. Even if such an error is minor or inadvertent, the entire exchange will be fully taxable.
Minor ID Foot Fault Renders Entire Exchange Fully Taxable. Exchangers may identify multiple replacement property and decide later which of the identified property to acquire as their actual replacement property. This can be very helpful to exchangers who need a little additional time to solve property-specific issues, conduct due diligence or complete their financing. However, exchangers must be very careful not to miss the deadline or over identify replacement property. Even a minor, inadvertent error in missing the deadline or over identifying renders the entire exchange fully taxable. The solution – acquire all replacement property within the 45-day identification period. By acquiring all replacement property within 45 days, exchangers are not required to identify replacement property.
For assistance in closing all replacement property within 45 days to avoid the ID requirement, stay tuned for Tip No. 2 “Avoiding the Risk and Hassles of Identification by Using DST Replacement Property to Close within 45 Days.”