1031 Replacement Property Identification Insight

A 1031 exchange defers the federal and state capital gains and recapture depreciation taxes triggered when selling and replacing real and personal property held in a business or for investment. The Internal Revenue Code Section 1031 requires meticulous attention to the rules. Identifying the potential replacement property by the 45^th calendar day is one of the rules required for each 1031 exchange, unless the replacement property is acquired within the first forty five days post-relinquished property closing.

Replacement Property Identification Procedure

No later than 11:59 PM of the forty-fifth calendar day post-closing, the exchangor must submit in a written document, preferably to the Qualified Intermediary, escrow agent or title company, a list of potential replacement properties. The list can also be given to any other person involved in the exchange other than the taxpayer or a disqualified person. The form can be delivered by hand, mail, fax or email provided it is dated and signed by the exchangor. Post-closing is interpreted as when the “benefits and burdens” of ownership have transferred. Real property closings are straight-forward given a Seller’s signature on the deed conveys the rights. Grodt & McKay Realty, Inc. v. Commissioner of Internal Revenue, 77 T.C. 1221, 1981 WL 11305 (1981) provides personal property transfer of ownership is fact oriented and dependent upon:

(1)    Whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity was acquired in the property; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property.

Replacement property identification cannot be unambiguous, implying that the description for real property be an address, legal description or map, while the Internal Revenue Service has stated that for personal property, make, model and year is sufficient.

Identification Property Rules

When identifying replacement property, the exchangor can use either the three property or two hundred percent rule. In the three property rule, up to three properties can be identified regardless of value. In the two hundred percent rule, four or more properties can be identified given the total value does not exceed two hundred percent of the relinquished property purchase price. The two hundred percent rule is typically used when the exchangor intends to acquire multiple properties. If either the three property rule or the 200 percent rule are violated, “the taxpayer is still treated as properly identifying any replacement property identified before the end of the identification period and received before the end of the replacement period, if the fair market value of the replacement property received is at least 95 percent of the aggregate fair market value of all identified replacement property” per Regulation § 1.1031(k)-1(c)(4)(ii)(A).

Replacement Property Identification Strategy

To reduce the burden of identifying replacement property by the forty-fifth calendar day post-closing, begin the replacement property search when close to or after entering into the relinquished property Purchase and Sales Agreement. An earnest money deposit can be forwarded to the replacement property escrow before closing on the relinquished property. The forty-fifth and one hundred and eighth calendar days can only be changed based upon the written notice of the Internal Revenue Service as found on the IRS website or if the exchangor is in a combat zone.

To learn more about 1031 exchanges, download a free “Ten 1031 Point Checklist” by clicking on the button here.