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Understanding the Sec. 1031 Identification Rules 

December 4, 2018

Section 1031 offers multiple benefits.  It’s not merely a means to allow real estate investors to switch between different properties in a tax-deferred manner.  It can also be used to help investors grow their wealth over the course of time. Say, for instance, an investor builds up substantial gains in a certain property.  That investor can then use a 1031 exchange to obtain a larger, more financially profitable property.  When that happens, the investor can take funds otherwise used to paid taxes and effectively use them on their own behalf. The wealth-building potential of Section 1031 is just one reason why investors need to be very careful when they select a professional to help them through the transaction. Whether it be a qualified intermediary, tax attorney, CPA or other professional, investors must be cautious when selecting assistance.  That’s because only one mistake can cause an otherwise passable transaction to fail. 

The Importance of Identification

One area of Section 1031 which which causes confusion is the area dealing with identification rules. The Treasury Regulations pertaining to delayed exchanges have specific rules for identifying replacement property. These rules must be strictly observed; if they’re not, a transaction will collapse. There are three primary “rules of identification” spelled out in the regulations.  Alongside these three primary rules,  there are several secondary rules.  There are also still other related rules which pertain to the receipt of identified property. Identification rules provide a good example of why it’s absolutely necessary to hire well-informed professionals to assist with a transaction.  Capable professionals will help investors both understand and properly observe these rules so that a like kind exchange transaction can be carried out without headache or worry.  

In this post, we will go over the three primary rules of identification.  We’ll seek careful to point out areas which commonly cause confusion. Hopefully, our readers can come away with a decent grasp of how these rules operate in reality. 

The Three Property Rule 

The “three property rule” is the most commonly used rule in Section 1031 transactions, and for good reason. This rule is the simplest and it is usually adequate to cover the majority of transactions. The three property rule can be stated as follows.  Investors need to identify no more than three potential replacement properties in the manner outlined by the regulations. If an investor needs to identify more than three properties, there are two other ways to obtain tax deferral.  The investor would need to comply with either the 200% rule or the 95% rule.

The big advantage of the three property rule is that the properties identified can be of any value.  That’s both individually and in aggregate. As long as the investor identifies no more than three properties, they can have an aggregate value of any amount. It’s possible, therefore, for an investor to sell a relinquished property with a value of, say, $1 million and identify three potential replacement properties with an aggregate value of $100 million and still fall within this rule.  

The simplicity of this rule is what makes it attractive to both investors and 1031 professionals.  It’s easy to both understand and communicate. Like kind exchange consultants generally counsel investors to stay within this rule.  That is, unless there’s a need to utilize one of the others.

The 200% Rule 

If an investor can’t comply with the three property rule, he will usually follow the so-called “200% rule”. This rule allows an investor to identify any number of potential replacement properties.  The caveat is that their combined value can’t exceed 200% of the gross sales price of the relinquished property. Here’s an example.  Suppose you sell a relinquished property for $2.5 million. You then proceed to identify four replacement properties, each with a value of $1 million. Right away, we can see that this scenario couldn’t be brought within the three property rule.  That’s because there are actually four identified properties. Here, the combined value of the properties doesn’t exceed 200% of the sale price of the relinquished property.  Accordingly, this scenario fits the 200% rule.  That is, $2.5 million for the relinquished property, so $5 million is the maximum aggregate value allowable.

If, however, the combined value of the identified properties were above 200%, there’s only one remaining option.  That is, the investor would have to comply with the 95% rule.  It’s described below.  That that would be the only way for the transaction to qualify for tax deferred treatment.  It’s also the investor’s only remaining tax deferral option. 

The 95% Rule 

The 95% rule states that an investor may identify any number of properties.  The combined value of those properties can be any amount. However, the caveat is that the investor must acquire at least 95% of the value which has been identified. Investors are typically encouraged to stay within either the three property rule or 200% rule.  The corollary is that they should avoid the 95% rule. That’s because the 95% rule places a heavy burden on investors.  That is, they must acquire 95% percent of the value of the relinquished property.  If they don’t, the entire transaction will fail.  

Example

Let’s look at a hypothetical situation.  Suppose an investor sells a property for $2 million and identifies 10 replacement properties.  Each has a value of $500,000. There the investor doesn’t meet either the three property rule or the 200% rule.  That’s because their combined value is $5 million, which is more than 200% of the value of the relinquished property.  In order to qualify for tax deferred treatment, the transaction can only qualify under the 95% rule. In that circumstance, the investor would literally need to obtain at least nine out of the 10 properties identified.  That’s because only then would he or she be able to acquire at least 95% of their combined value. Most realistic scenarios, though, won’t be as straightforward as this hypothetical. Unfortunately, nearly every realistic scenario which falls within the 95% rule will be approximately as difficult to complete. 

Get Help Understanding the 1031 Identification Rules

The identification rules of 1031 can be very tricky, particularly when applied to real world scenarios. This is precisely why it is so important to hire competent professionals.  Investors utilizing 1031 tax deferred strategies are usually dealing with multi-million dollar transactions.  Skimping on professional navigators through these complex rules is penny-wise but pound foolish.  The tax professionals at Mackay, Caswell & Callahan, P.C., have worked hard to master this complicated material.  We do so that we can deliver the best possible service to our clients. We’ve learned the tough things so that you can maximize your earnings the easy way. So if you need a 1031 transaction consultation, or have other debt, tax or business law matter, please reach out.  With offices in much of New York including Albany, New York City, Rochester and Syracuse, a New York tax attorney can get started on your issue right away. 

Image credit: Mark Moz

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