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"Answering All Your Questions About Property Identification Rules For 1031 Exchange"

Confused about all the different rules regarding property identification in a 1031 exchange? This article will answer all your questions and help you understand these rules so you can successfully defer your capital gains taxes using a 1031 exchange.

To defer capital gains taxes using a 1031 exchange, it's essential to identify potential replacement properties in writing by midnight of the 45th calendar day after the close of escrow on the relinquished property. Failure to do so means that your transaction will be recognized a taxable sale rather than a tax-deferred exchange.

So, to help you navigate the 1031 exchange process, let's answer all those burning questions about how, and when, to identify replacement properties.

What Is The "Like-Kind" Property Rule?

According to IRS rules, only like-kind replacement properties may be identified for use in a 1031 exchange. Generally, real properties in the United States held for investment or business purposes are considered to be "like kind" to one another, regardless of their grade or asset class.

Can I exchange personal property for real property?

No. While both real property and personal property can be exchanged without recognition of gain under IRC section 1031, it's important to note that real property is not like kind to personal property and vice versa. So, real property can only be exchanged for real property, and personal property can only be exchanged for personal property.

Can I exchange US-based property for foreign property?

No. Only property located in the United States and certain U.S. territories[1] may be exchanged without recognition of gain under IRC section 1031. However, property in the United States is not considered like kind to property outside the United States and vice versa.

Can I exchange residential property for commercial property? (or vice-versa?)

Yes. Residential property held for investment (such as rental property) may be exchanged for commercial property and vice versa.

Can I exchange my personal residence or vacation home for investment property?

No. A taxpayer's personal residence or vacation home may not be exchanged for investment real estate of any kind under IRC section 1031. Why? Because it is not held for investment or business purposes. (However, there are other tax shelters for the proceeds of the sale of personal residences.)

Can I exchange raw [undeveloped] land for an improved property?

Yes. Raw land may be exchanged for improved real estate and vice versa.

Can land conveyed without its property be exchanged with land conveyed with its' property?

Yes. Land that is conveyed without its improvements (ground lease ownership) and land conveyed with its improvements (fee simple ownership) are like kind and may be exchanged.

NOTE: Property conveyed without its land has special rules:

Property improvements conveyed without land (leasehold interest) do not always qualify. Specifically, a leasehold interest must have a ground lease with at least 30 years remaining (including renewal options) to qualify for 1031 exchange. A leasehold interest with fewer than 30 years remaining does not qualify for like kind exchange.

Are there specific types of property that are excluded from the 1031 exchange?

Yes. Certain types of property are specifically excluded from tax-deferred treatment under IRC Section 1031. Section 1031 does not apply to exchanges of:

" Inventory or stock in trade

" Stocks, bonds, or notes

" Other securities or debt[2]

NOTE: Delaware Statutory Trust and Tenant-in-Common interests do qualify and are not a part of these specific exclusions.

" Partnership interests

" Certificates of trust

Are there other rules I need to be aware of?

Yes. One important rule to remember is to only identify property held for business or investment purposes.

Only property that will be held for productive use in a trade or business or for investment qualifies for use in a 1031 tax-deferred exchange. Therefore, it is crucial for an investor to identify property intended for business or investment.

Important things to keep in mind:

" Intent: If a replacement property will be held with the intent to be used productively in a trade or business or investment and yet it turns out to be unproductive, it will not nullify the 1031 exchange.

" Predominant Use: If one will occasionally rent out a property that will otherwise be used as one's personal residence or vacation home, or if one intends to operate a home office in a property, this does not qualify as a replacement property in a 1031 exchange. Why? Because the predominant use of such property would not be for investment or business purposes.

Conversely, if one will occasionally use a rental property for personal purposes, it may nevertheless be used as a replacement property in a 1031 exchange.

It is important that the Safe Harbor limits below are adhered to, however, to ensure proper consideration of a property's status for 1031 exchange purposes.

" Safe Harbor: Revenue Procedure 2008-16 specifies conditions under which the IRS will not challenge one's intent to hold a replacement property for business or investment purposes.

For example, if:

o a property is held for 2 years or more, and

o during each of the 2 years after the exchange it is rented out for 14 days or more, and

o during each of the 2 years after the exchange it is not used for personal purposes for any more than 14 days, or 10%, of the duration for which it is rented out

o then its intent to be held for investment purposes will not be challenged by the IRS.

Why do I have to choose one of these 3 rules below to successfully defer my capital gains taxes in a 1031 exchange?

" 3-Property Rule

" 200% Rule

" 95% Rule

Answer: Failure to comply with one of these identification rules above will result in the taxable recognition of capital gain. To follow them requires advanced planning.

Potential replacement property identifications may be revoked prior to the identification deadline, however once midnight on the 45th calendar day after the close of escrow on the relinquished property elapses, unrevoked property identifications cannot be changed. Keep in mind: This may commit an investor to acquiring property that might not otherwise be desired in order to comply with the rules and successfully avoid the capital gains taxes.

What is the 3-Property Rule?

An investor may identify up to 3 potential replacement properties, regardless of the aggregate market value of the properties, and acquire as many of the properties identified as desired to complete the exchange.

What is the 200% Rule?

An investor may optionally identify more than 3 potential replacement properties, if their aggregate market value does not exceed 200% of the market value of the relinquished property. An investor may acquire as many of the properties identified using the 200% Rule as desired to complete the exchange.

What is the 95% Rule?

An investor may optionally identify any number of potential replacement properties, regardless of their aggregate market value, if the investor acquires 95% of the aggregate market value of all the properties identified using the 95% Rule.

How long do I have to identify a potential replacement property?

The time period is exactly 45 calendar days long. The first day after the close of escrow is the first day. The replacement property identification must take place by midnight on day 45. Note: If this day falls on a weekend or holiday, the deadline is not extended.

[Use our 1031 Time Limit Calculator.]

Are there any exceptions to the 45 Calendar Day rule?

Yes. But, exceptions may only be declared by the President of the Unites States, which may be done on extremely rare occasions, such as natural disasters, that affect the properties or parties involved with the 1031 exchange process.

How do I submit my 1031 replacement property identification?

IRC section 1031 requires property identifications to be "hand delivered, mailed, telecopied, or 'otherwise sent.'" Property identifications today are typically emailed, and recipients reply by email, with the property identifications attached to the reply, to confirm receipt.

To Whom do I submit my 1031 replacement property identification?

The standard practice today is to submit property identifications to one's Qualified Intermediary, who will be party to the official Exchange Agreement and therefore demonstrably "involved" in the exchange.

Are there other examples of "involved parties" allowed by the IRS I should know about?

Other examples of "involved" parties include the person obligated to transfer the replacement property to the taxpayer (which can be different from the Qualified Intermediary in certain circumstances), any party to the exchange, an escrow agent, and a title company.

Note: IRS Fact Sheet 2008-18 specifically disqualifies one's attorney, real estate agent, accountant, or similar persons who act as one's agent from receiving one's 1031 replacement property identifications.

What do I need to include when I submit my 1031 replacement property identification?

Most Qualified Intermediaries have years of experience to help facilitate this process and have standardized paperwork available to make it easy for you. However, at minimum, property identifications must include specific, unambiguous descriptions of each property. This may include legal descriptions, street addresses, Assessors Parcel Numbers, and any recognized building names.

NOTE: If one is using the 200% rule and planning to acquire a fractional interest, such as a Tenant-in-Common or Delaware Statutory Trust interest, one ought to specify the percentage or dollar amount being considered for acquisition. Why? Because failure to do so may be interpreted as an identification of the entire property. This may result in the total market value of one's property identifications being greater than 200% of the value of one's relinquished property, which could trigger a taxable event.

Are there alternatives to these 1031 property identification methods?

Yes. If a Letter of Intent (LOI) or contract is signed by its parties prior to the end of the 45-day identification period, it satisfies the identification requirement[3]. Similarly, closing escrow on a replacement property prior to the 45-day identification deadline would also satisfy the property identification requirement.

Can you help me navigate the 1031 exchange process?

Yes, we can! The experts at 1031Gateway can connect you to 1031 professionals, education, and tools. Our team can also provide access to an extensive list of vetted on- and off-market replacement properties, including:

" Sole-ownership triple net properties

" Bank-owned properties

" Discounted real estate

" Fractional real estate interests (TIC or DST)

We can also help you find properties structured for a 721 exchange into a Real Estate Investment Trust (UPREIT).

How can I get started?

It's easy! Just fill out the form at the top of the page to learn more today.

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[FOOTNOTES]

[1] "In the United States" in this case includes Washington D.C. and, in certain circumstances, the U.S. Virgin Islands, Guam, and the Northern Mariana Islands; it excludes other territories such as Puerto Rico, American Samoa, and the Minor Outlying Islands.

[2] Although securities are generally excluded, certain real estate structured for sale as securities do qualify for tax-deferred treatment in a 1031 exchange. Revenue Procedure 2002-22 lays out guidelines by which a Tenant-in-Common interest may qualify, and Revenue Ruling 2004-86 describes how an interest in a Delaware Statutory Trust may be acquired without recognition of gain under IRC section 1031.

[3] Since accepted LOIs qualify as property identifications, it is important not to invalidate one's use of the 3-Property Rule by effectively "identifying" more than three properties, including any unrevoked property identifications submitted to the QI and separate LOIs.