Identifying replacement property with a qualified intermediary (QI) is one of the most essential parts of a 1031 exchange, so it is important to know the identification or ID rules and how it all works. First, exchangers need to know that once they sell their relinquished property, and their funds are transferred to a qualified intermediary, they have 45 days in which to ID the property or properties they might like to purchase as a replacement with their qualified intermediary. It is also important to note that in order to complete a successful 1031 exchange, an investor needs to replace or purchase a new property or properties of equal or greater value than the property they sold.
The 45 day ID period begins once an exchanger sells the property they are exchanging. When an exchanger identifies replacement properties during the 45 day ID period, it can be thought of as writing or identifying properties on a whiteboard. At any time, an exchanger can add or remove properties from their ID list as long as it is in the 45 day window. But, on day 46, whatever has been identified at that time, becomes set in stone.
Generally speaking, in order to identify a property with a qualified intermediary, most QIs require the address, legal description of the property, and the amount of cash and debt (if any) that the exchanger will be investing in that property. I recommend asking your qualified intermediary if they need any additional information for ID. For example, if you are identifying a DST or Delaware Statutory Trust, you may also need the ownership percentage for your investment as well. When working with a qualified intermediary, they will likely have their own ID form that an exchanger can use to fill out all of the required information for identification purposes.
There are three separate rules that an exchanger can follow when identifying replacement property; the three property rule, the 200% rule, and the 95% rule. The exchanger can decide, with their qualified intermediary and tax or legal counsel, which rule is most suitable for their exchange.
Rule 1: The Three Property Rule
The first and most well-known rule, is the three property rule. This rules states that an exchanger can identify up to three different replacement properties, with no limit on the value of those properties. An exchanger does not have to identify three properties, but I believe it is a good idea to always identify at least three options, in the event that something happens to the first option outside of the 45 day window, then the exchanger has a backup to avoid ruining their exchange. In order to complete a successful exchange in which no taxes are due, an exchanger needs to replace the property they sold with a property of equal or greater value. The three property rule can be used in various ways. For example, if an exchanger sells a property for $1M, they can identify three different properties valued at $1M or more for replacements, and close on at least one of them to complete a successful exchange. Or, they can identify two properties for $500K and one property for $1M. They could either close on the two for $500K or the one property for $1M that they have identified to complete their exchange.
Rule 2: The 200% Rule
The second rule, which is also used often, is the 200% rule. This rule states that an exchanger can identify any number of properties they want, as long as the total value of the properties identified is not more than 200% of the value of the property they sold. This means if they sold a property for $1M, they could identify any number of properties, as long as the value of those properties does not exceed $2M, or 200% of $1M. As an example, if an exchanger sold a property for $1M, they could identify 10 different properties valued at $200K each. But in order to complete a successful exchange they will need to close on at least 5 of those properties to replace the total value of $1M or more. This rule is commonly used with DSTs or Delaware Statutory Trusts. One of the benefits of using DSTs in an exchange is that they can provide diversification because minimum investment requirements are usually around $100K. This means if an exchanger sold a property for $1M, they can identify and close on up to 10 different DSTs if they wanted to and if they wanted a passively owned, diversified real estate portfolio.
Rule 3: The 95% Rule
The last rule that is rarely used is, the 95% rule. The 95% rule states that an exchanger can identify any number of replacement properties and there is no limit on the value of those properties. However, it is rarely used because the exchanger must close on or acquire at least 95% or more of the total value of the properties identified in order to complete a successful exchange. The 95% rule can be risky. For example, let’s say an exchanger identifies 5 properties using the 95% rule. One of the properties that was identified ends up being sold to another buyer. This could potentially ruin the whole exchange. Even if the other 4 properties were successfully closed, the total value of 4 closed properties was likely less than 95% of the value of the properties identified in this example. Failing to close on or acquire 95% or more of the total value of replacement properties identified could cause the whole exchange to be disqualified.
It is recommended to always discuss 1031 exchange identification options with a qualified intermediary and tax or legal counsel, to determine which identification rule is most suitable for your exchange.
