What do the 1031 identification rules entail?
Within 45 days of the sale of the relinquished property, the investor must inform the Qualified Intermediary (QI) or a qualified third party in writing which properties they are selecting as replacements. They can choose up to three properties with the Three-Property Rule, any number of properties as long as their total value doesn’t exceed 200% of the relinquished properties’ value with the 200 Percent Rule, or any number of properties as long as they acquire at least 95% of the identified value with the 95 Percent Rule. Let’s review the three (3) rules in more detail below:
Identification of up to three properties regardless of the total value of the property identified.
Identification of any number of properties wherein the combined FMV (fair market value) does not exceed 200 percent of the relinquished properties’ FMV.
Identification of any number of properties regardless of the aggregate FMV, as long as at least 95 percent of the value identified is ultimately acquired.
These rules, combined with the lower investment requirements of the Delaware Statutory Trust (DST), allow for diversification to mitigate investment risks. The replacement property must be acquired within 180 days of the sale of the relinquished property. If all replacement properties are acquired before Day 45, no identification is necessary, which is advantageous for DST investments that can be acquired quickly.
To avoid taxable “boot” in an exchange, the replacement property must be of equal or greater value than the relinquished property, the debt on the replacement property must be equal or greater than that on the relinquished property, and all cash proceeds from the sale of the relinquished property must be reinvested. Any shortfall in debt or property value may result in boot, subject to taxation at a higher rate of 25%. Let’s review the rules to avoid taxable boot in more detail below:
- The replacement property must be of equal or greater value than the relinquished property.
- The debt held by the replacement property must be of equal or greater value than the debt held by the relinquished property unless the investor offsets lower debt on the replacement property by adding cash to the exchange.
- All the cash proceeds from the relinquished property sale must be reinvested into the replacement properties.
If the above requirements are not met, the exchange is not invalid. However, the amount of cash taken out of the exchange or by which the debt, or property value falls short of the stipulated requirements is considered “boot” and subject to taxation. Unfortunately, the boot is first taxed as a deprecation recapture at the higher federal tax rate of 25 percent.