Understanding §1031 Tax Deferred Exchange Identification Rules

Occa­sion­al­ly we receive a fran­tic call from an investor who is in the mid­dle (some­times at the end) of their 45-day iden­ti­fi­ca­tion peri­od.  Under­stand­ing the iden­ti­fi­ca­tion rules pri­or to enter­ing a poten­tial exchange may be the pre­ferred path.

By Al DiNi­co­la, AIF®, CEPA ™
adinicola@namcoa.com
June 9, 2023
DST 1031 Spe­cial­ist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC

The 1031 clock starts tick­ing upon the clos­ing of the relin­quished prop­er­ty. The 45 days are cal­en­dar days and no mat­ter what day of the week the 45^th day falls the iden­ti­fi­ca­tion peri­od ends.  Even if the 45^th day is a week­end or hol­i­day.

The investor (along with a finan­cial advi­sor, real estate bro­ker or oth­er par­ties) will start eval­u­at­ing poten­tial replace­ment prop­er­ties dur­ing the 45 days.  One point to make clear is that dur­ing the 45 days the investor may change the prop­er­ties on the 45-day list.  Changes may be nec­es­sary espe­cial­ly if the intend­ed replace­ment prop­er­ty is no longer suit­able for the investor, is acquired by oth­er investors or under oth­er cir­cum­stances.

With­out a QI, noth­ing else mat­ters.

The qual­i­fied inter­me­di­ary (QI) is a crit­i­cal play­er in the exchange process. We can­not stress enough the impor­tance of engag­ing a QI as soon as the investor has decid­ed to sell the prop­er­ty ref­er­enced as the relin­quished prop­er­ty. If the investor has sold the prop­er­ty with­out a QI being part of the trans­ac­tion the exchange can­not be exe­cut­ed.  Even if the title com­pa­ny is hold­ing the sales pro­ceeds in their escrow account. We would also strong­ly encour­age lan­guage in the sales con­tract (of the relin­quished prop­er­ty) to reflect the sell­er intends on exe­cut­ing a 1031 tax deferred exchange and the buy­er shall not object to the process. Once the prop­er­ty is sold and the QI has received the pro­ceeds of the sale the QI typ­i­cal­ly will send a form to the investor to fill out and send back to the QI. The IRS requires this form to be sub­mit­ted to ensure that prop­er­ties ulti­mate­ly acquired were reflect­ed on the form.

Iden­ti­fy by putting it in writ­ing.

There are spe­cif­ic require­ments set out in sec­tion 1031 regard­ing the acknowl­edg­ment or com­mit­ment to a cer­tain list of poten­tial replace­ment prop­er­ties. The investor is referred to as the Exchang­er and is required to sub­mit a signed doc­u­ment to the QI. The QI is han­dling the details of the exchange sale. There are dif­fer­ent accept­able meth­ods of sub­mit­ting the list to the QI.  Some Exchang­ers may hand deliv­er the list. Oth­er  Exchang­ers will use email or fax to send the list.  A text mes­sage is not a pre­ferred method of com­mu­ni­ca­tion. This list must be received by the QI by the end of the 45^th day.  We have worked with Exchang­ers who engaged with a QI on the west coast and have pushed the enve­lope so to speak with sub­mis­sions.  Best prac­tices would encour­age the Exchang­er to have the final 45-day list sub­mit­ted so that the QI may acknowl­edge receipt of the doc­u­ment.

If there is a change in the make­up of the list, we strong­ly encour­age the Exchang­er to send the new list with a nota­tion that this cur­rent list super­sedes or voids any pre­vi­ous list sub­mit­ted on a pre­vi­ous date and list the pre­vi­ous doc­u­ment date. If there are a num­ber of changes dur­ing the 45-days, the exchang­er may want to title the list with a ver­sion num­ber (v.1. v.2) and when the ulti­mate list is sub­mit­ted mark the list FINAL.

ID Details mat­ter.

 Depend­ing on the prop­er­ty the iden­ti­fi­ca­tion may be very easy or com­pli­cat­ed.  In the case of a sin­gle prop­er­ty there may be only one address and a tax iden­ti­fi­ca­tion num­ber sup­plied by the prop­er­ty apprais­er office.  When pur­chas­ing land as a replace­ment prop­er­ty the legal descrip­tions may be more involved and have meets and bounds descrip­tion.  Clar­i­ty is the key for the iden­ti­fi­ca­tion. In the case of frac­tion­al own­er­ship such as Ten­ants in Com­mon (TIC) or a Delaware Statu­to­ry Trust (DST) many QIs (and the IRS) would pre­fer to have a per­cent­age of own­er­ship espe­cial­ly if not pur­chas­ing the entire prop­er­ty. Even in a part­ner­ship inter­est a full descrip­tion and per­cent­age of own­er­ship is required to elim­i­nate any con­fu­sion or chal­lenge if there is an IRS audit on the exchange.

Review­ing the finan­cial require­ments

As a brief review of the finan­cial require­ments the Exchang­er needs to :

1. Replace the relin­quished prop­er­ty with equal or greater val­ue
2. Replace any debt that was paid off on the relin­quished prop­er­ty.
3. Use all the cash the QI is hold­ing.

Let’s review the rules for iden­ti­fy­ing prop­er­ties.

The first rule (and poten­tial­ly most often used) is the Three Prop­er­ty Rule.

This may be the sim­plest of the rules for fill­ing out the list.  You may iden­ti­fy three prop­er­ties no mat­ter what the fair mar­ket val­ue may be. For exam­ple, if your relin­quished prop­er­ty was sold for $500,000 you may iden­ti­fy three prop­er­ties with a total val­ue of $1,500,000.

If you have iden­ti­fied three prop­er­ties that were less than the replace­ment price you may acquire more than one prop­er­ty.  If buy­ing only one prop­er­ty, the oth­er iden­ti­fied prop­er­ty will be back-ups if for some rea­son the first prop­er­ty falls through.

Poten­tial greater flex­i­bil­i­ty with the 200% Rule

The 200% rule can be con­fus­ing at times when attempt­ing to cal­cu­late the val­ues. In sim­ple terms you may iden­ti­fy as many prop­er­ties as you want, as long as the total val­ue does not exceed 200% of the fair mar­ket val­ue of your relin­quished prop­er­ty.  What com­pli­cates this to a cer­tain degree would be that the iden­ti­fied prop­er­ties will include the total acqui­si­tion price includ­ing any debt that is being replaced. If we use the same $500,000 in the exam­ple above and if it is an all-cash trans­ac­tion you may list as many prop­er­ties as you want up to a total of $1 M.   If you are financ­ing part of the replace­ment prop­er­ties, you will need to eval­u­ate the spe­cif­ic LTVs on each prop­er­ty and then iden­ti­fy as a total price.

Sel­dom used 95% Iden­ti­fi­ca­tion Rule

In all our years of deal­ing with 1031 exchanges (includ­ing DST replace­ment) we have not seen any investor uti­lize the 95% Rule. This enables an investor to iden­ti­fy as many prop­er­ties as they wish regard­less of val­ue, as long as they pur­chase 95% of all prop­er­ties iden­ti­fied. Any­thing less would jeop­ar­dize the exchange.

Next steps

The first step to a suc­cess­ful exchange may start with hir­ing the right Qual­i­fied inter­me­di­ary (or accom­moda­tor). While the cost may vary a few hun­dred dol­lars, you want an expe­ri­enced QI. Under­stand­ing your replace­ment options pri­or to enter­ing into an exchange is an impor­tant step.  Each of the rules has pos­i­tives and draw­backs. 

DST Flex­i­bil­i­ty.

Delaware Statu­to­ry Trust (DST) has pro­vid­ed a solu­tion for many investors who become exchang­ers. The DST options pro­vide for diver­si­fi­ca­tion of replace­ment prop­er­ties and can sat­is­fy debt replace­ment with non-recourse debt.  There is also flex­i­bil­i­ty in bal­anc­ing the debt with cer­tain DST prop­er­ties enabling the exchang­er to poten­tial­ly spread risk out over a diver­si­fied port­fo­lio of prop­er­ties.  The same $500,000 prop­er­ty exam­ple from above may enable an investor to invest in a DST port­fo­lio of three to four prop­er­ties with dif­fer­ent asset class­es as well as geo­graph­ic diver­si­fi­ca­tion.

Final thought.

We opened this arti­cle with a fran­tic call from investors who were in the mid­dle or end of their 45-day iden­ti­fi­ca­tion peri­od.  We have suc­cess­ful­ly assist­ed investor/exchanger who had only two days remain­ing in their iden­ti­fi­ca­tion peri­od.  While this is not the pre­ferred tim­ing, we have access to a wide vari­ety of DST replace­ment prop­er­ties. Investor who have spent time review­ing the DST alter­na­tive can make a deci­sion on mov­ing for­ward.

Con­tact us for addi­tion­al infor­ma­tion on the DST struc­ture and func­tion for your poten­tial invest­ment solu­tions.

DSTs are not for all investors. The acqui­si­tion of a DST is for accred­it­ed investors only. Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your 1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC 1031Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus. Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor. NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin ‑Sher­wood Rd, Suite 200 Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC