There are very specific requirements for identifying and acquiring potential replacement properties through your 1031 Exchange transaction. The prospective replacement properties identified as part of your 1031 Exchange do not need to be under contract or in escrow when you identify them.
The replacement properties that you are considering for acquisition as part of your 1031 Exchange should be identified to your Qualified Intermediary (Accommodator) and must be identified no later than midnight of the 45th calendar day following the close of your relinquished property sale transaction. For example, if the sale of your relinquished property closed on October 31, your first day of your 45 calendar day identification period would be November 1 and the 45th calendar day deadline would be December 15th. You might want to read our article entitled 1031 Exchange Deadlines and Due Dates.
There has been significant debate over the years as to who the actual Identification of Replacement Property Form should be delivered to. Section 1.1031 of the Department of the Treasury Regulations requires the identification of replacement property be made or delivered to a "party involved in the 1031 Exchange" transaction. The debate essentially centers around how you define a party involved in the 1031 Exchange transaction.
Sticking to the basics is always the best and most accurate method to use when analyzing this issue. Your 1031 Exchange transaction is structured using a 1031 Exchange Agreement. Therefore, the only acceptable and safe definition of the parties involved in your 1031 Exchange transaction would be the parties to the 1031 Exchange Agreement itself. There are typically only two parties to the agreement — you and your Qualified Intermediary (Accommodator). Therefore, making or delivering the identification of replacement property to the Qualified Intermediary is the only safe answer to this question.
Identifications made to any other party raises the question as to whether your identification will qualify as a valid ID of replacement property and will depend on how the Internal Revenue Service, state taxing authorities, and/or court decisons ultimately define a party involved in the 1031 Exchange transaction.
In fact, the Internal Revenue Service issued a Fact Sheet (FS-2008-18) on March, 5, 2008 that helps clarify who you can and can not ID your like-kind replacement properties to. Here is a quote directly from the Fact Sheet:
"The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient."
Replacement properties must be clearly and specifically (unambiguously) identified to the Qualified Intermediary using the common property (street) address, and/or the legal description, and/or the Assessor's Parcel Number (APN). Generally, the more specific the indentification the better; the more general or less specific the more risk that the 1031 Exchange could be disallowed during a Federal or state audit.
Be sure to identify the exact percentage interest in the property that you are considering acquiring if you are identifying a fractional or partial interest such as a 5% undivided interest in a tenant-in-common investment property, Delaware Statutory Trust (DST) or other co-ownership property, or identify the unit number if you are identifying a condominium property. Identifying only the property address without a percentage or unit number could be interpreted to be an identification by you of the entire property (100%) and a partial acquisition may not satisfy the 1031 Exchange requirements.
Ultimately, you must acquire replacement property that is substantially the same as what you identified. Therefore the identification of replacement property can be somewhat complicated, especially in Build-To-Suit (Improvement) 1031 Exchange transactions. You should consult with Exeter 1031 Exchange Services, LLC and your professional legal and tax advisors in the preparation of your identification of replacement property. Exeter 1031 Exchange Services, LLC makes the identification process easier for its clients by providing an Identification of Like-Kind Replacement Property Form.
You must comply with at least one of the following identification rules or exceptions when completing the identification of your replacement properties:
Three (3) Property Identification Rule
The three (3) property identification rule limits the total (aggregate) number of replacement properties that you can identify to a maximum of three (3) potential replacement properties. The vast majority of investors today use this three (3) property identification rule.
You could acquire all three of the identified replacement properties as part of your 1031 Exchange, but most investors only acquire one of the three identified properties. The second and third identified properties are merely identified as back-up replacement properties in case you can not acquire your first identified property.
You will skip the three (3) property identification rule and use the 200% of Fair Market Value Rule if you are trying to diversify your investment portfolio and wish to identify more than three (3) replacement properties.
200% of Fair Market Value Identification Rule
You can identify more than three (3) replacement properties as long as the total (aggregate) fair market value of all the identified replacement properties does not exceed 200% of the total (aggregate) Gross Sale Price of your relinquished property(ies) sold in your 1031 Exchange. The limitation is only on the total (aggregate) identified value. There is no limitation on the total number of like-kind replacement properties.
For example, if you sold relinquished property(ies) in the amount of $2,000,000 you would be able to identify as many replacement properties as you want as long as the total (aggregate) value of the identified replacement properties does not exceed $4,000,000 (200% of $2,000,000).
95% Identification Exception
Its good to have choices, but be careful with this exception. It is an exceptionally useful tool under the right circumstances, but can present some tricky problems.
You may need to identify significantly more like-kind replacement properties than the first two identification rules permit. There is no limit as to the total (aggregate) number or value of identified like-kind replacement properties permitted under the 95% exception as long as you actually acquire and close on 95% of the value identified.
However, if you do not acquire and close on at least 95% of the value of the identified like-kind replacement properties the entire 1031 Exchange transaction will be disallowed.
There are benefits and challenges with each of these 1031 Exchange identification rules and requirements for replacement property. Exeter 1031 Exchange Services, LLC is always available to assist you and your advisors in deciding which of the the above 1031 Exchange ID rules would be best suited for your 1031 Exchange transaction.
Clients and their professional advisors are welcome to contact any of our 1031 Exchange Administrators at one of our national branch office locations for assistance.