In a 1031 Exchange, when replacement property is to be acquired after the 45th calendar day post relinquished property closing, the replacement property must be formally identified. Failure to follow the strict rules could be grounds for the Internal Revenue Service to disqualifying the 1031 Exchange. Taxpayers initiating a 1031 Exchange for personal or real property held for productive use in a trade, business or for investment should acquaint themselves with identification requirements to avoid misinterpretation and the angst of learning afterwards the lessons of botched like-kind identification.
1031 Exchange
In a 1031 Exchange there are two phases, the identification phase and the acquisition phase. Both start following the closing of the relinquished property with the identification phase ending on the 45th calendar day at 11:59 PM and the replacement property phase on the 180th calendar day. Exchange Agreements will typically include a paragraph on Regulation § 1.1031(k)-1(b)(2) further stating that the “Exchangor shall designate the Replacement Property during the Identification Period in a manner that complies with Regulation(k)-1(c) and (e).”
Identify to Qualified Intermediary
Given the intent is to defer the entire capital gain, the like-kind replacement property sales price must be equal to or greater than the relinquished or old property sales price. Consequently, the properties identified can follow the three property rule where up to three properties can be identified without concern to their sum or four or more, given the sum does not exceed two hundred percent of the relinquished property sales price. If two hundred percent is exceeded, then 95 percent of what was identified must be acquired.
If an undivided interest in the replacement property, rather than the entire property is to be acquired, then the percentage interest should be identified. If the entire property is identified and 70 percent is acquired, then the Internal Revenue Service may determine the Exchangor did not acquire what was identified.
The property characteristics are listed on an Identification Form such as the address, including unit number, city and state for real property or manufacturer, model number, year made, or tail number for personal property such as aircraft. Maps, legal descriptions or parcel numbers may be used if an address is not appropriate for farms or land. The description cannot be unambiguous. The Exchangor signed and dated Identification Form is submitted preferably by fax, mailed, emailed, or hand delivered to a party involved in the 1031 Exchange including:
- The person obligated to transfer the replacement property to the taxpayer regardless of whether that person is a disqualified person per Reg. § 1.1031(k)-1(c)(2)(i); or
- Any other person involved in the exchange other than the taxpayer or a disqualified person per Reg. §1.1031(k)-1(c)(ii).
Sending the Identification Form to the Qualified Intermediary eliminates interpreting the keywords “party involved in the 1031 Exchange.”
Once the 45th calendar day passes, the Identification Form cannot be changed. The Exchangor must acquire one or as many of the replacement properties as needed to fulfill Regulation requirements. If the intent is to acquire one of the multiple properties identified, circle the word “Yes” to the question on the Form “Exchangor will only acquire one of the identified properties.” By doing so, once one of the properties is acquired, if there are exchange funds left over, the Qualified Intermediary can reimburse those funds without having to wait for the end of 180 calendar exchange period.
Exchange Funds Return
If properties have been identified and cannot be purchased for reasons such as bank did not approve a short sale, property is destroyed, or inability to negotiate the sales price, the Exchangor may request return of their exchange funds due to “material and substantial contingency that is beyond the control of the investor.” The (g)(6) limitations are very specific. Limitations on Exchangor’s right to exchange account are typically found in the Exchange Agreement defining under what conditions the Exchangor can have access to their proceeds. One of those conditions is “upon or after the receipt by Exchangor of all replacement property to which the Exchangor is entitled to” in the Exchange Agreement. This implies that if property cannot be acquired, the funds cannot be returned until the end of the exchange or the 180th calendar post-closing. A Qualified Intermediary who returns exchange funds earlier than allowed by the (g)(6) limitations risk invalidating all their exchanges.
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