Property identification is a key part of any 1031 exchange, so here’s a guide to the proper procedure.
Taxpayers perform Section 1031 like-kind exchanges in order to defer capital gains taxes, depreciation recapture, and other taxes on the sale of business or investment property. By deferring these taxes, they’ll have more money to invest in their replacement properties. But tax deferral only occurs if the exchange follows IRS procedure; if not, the exchange will fail, and the sales proceeds will be subject to taxation.
There are many rules that apply to 1031 exchanges. One is that you must work with a Qualified Intermediary (QI) that can hold your sales proceeds during the exchange. Another is that you must identify properties by the 45-day deadline. Which properties you have to identify will depend on the particulars of your exchange.
The 1031 45-day identification deadline
The 1031 exchange timeline for a forward exchange begins on the date the sale of the relinquished property closes. You have 45 days from that date of sale to identify your replacement properties. You can identify up to three potential replacement properties (more in some instances), and the properties you ultimately acquire by Day 180 must be among those identified.
Since you don’t have to acquire all identified properties, it’s a good idea to use all three identification slots in case your preferred property falls through. Many exchangers use a Delaware Statutory Trust (DST) as a backup option to protect against a failed exchange.
If you don’t identify your replacement properties in writing by Day 45, your exchange will fail. You’ll take receipt of your exchange funds on Day 46, and the sales proceeds from your relinquished property sale will be subject to all applicable taxes.
If you identify properties early, you have the ability to change your mind. For example, if you identify a property on Day 15, you can identify another (or additional) property before Day 45 and override the original identification.
If you acquire a desired property before the 45-day identification deadline, you do not have to identify it first. And if you plan to acquire multiple properties, but acquire only one of them before Day 45, you still need to identify the others in writing. In that case, the already-acquired property would count toward the three-property rule or 200% rule.
In a reverse exchange, the timeline is the same, but the procedure is a bit different. Exchangers performing reverse exchanges must identify the relinquished properties, not the replacement properties. Since the relinquished property has not yet been sold, the timeline begins on the date the replacement property is parked with the Exchange Accommodation Titleholder (EAT). From that point, you have the same 45-day period to identify your properties.
Regardless of what kind of exchange you’re performing, you need to identify properties in writing according to IRS guidelines. It is not enough merely to select your preferred properties and write it down – there are specific parties who need to be notified.
Who needs to be informed of your 1031 exchange replacement properties
Certain parties have to be provided with the written notification of your identified replacement properties. In addition, all parties involved need to know that their transactions are part of a like-kind exchange, even if they are not involved in the property identification step. In a forward exchange, you must inform the buyer of the relinquished property that the transaction is part of an exchange. The same goes for the seller of the replacement property in a reverse exchange. You should consult with your tax and legal advisors on the contractual stipulations required to ensure these deals conform to 1031 regulations.
When identifying your replacement properties, the two main parties who need to be notified are the Qualified Intermediary and the seller of the replacement property. While it is a good practice to notify your tax and legal advisors, simply telling your attorney or accountant which properties you intend to purchase won’t satisfy the identification requirement as these are considered disqualified persons.
Any other parties involved in the exchange must also be notified, including escrow agents, title companies, or DST sponsors (if one of the identified properties is an interest in a DST)
How should I identify my 1031 exchange replacement properties in writing?
Identification should come in the form of a written document signed by the exchanger. This document should include an unambiguous description of the property. That means a full legal description, with the street address and any distinguishable name (for example, the name of an apartment complex). The property type should also be included. If the property is a single unit, such as a condominium or retail space, the unit number must be specified.
Another important aspect of property identification is that the property acquired must be substantially the same as the property identified. This raises complications for improvement exchanges, as the property acquired may include structures built between the time of identification and the date of sale.
If improvements to the property are planned, the identification document should include a description of the state of the property at the time of writing as well as the expected state when ownership is to be transferred, including precisely what is to be constructed on the property.
When an identified property involves fractional ownership, such as an interest in a DST, then the percentage of ownership should be included, along with the details of the properties in the DST’s portfolio.
Because improper identification can result in a failed exchange, this step is critical and must be carried out with precision, especially if you’re identifying multiple properties, performing an improvement exchange, or using a DST as a replacement property. You need to work with service providers who understand the nuances of these types of exchanges and what is required to satisfy IRS regulations.
JTC’s 1031 exchange team has specific expertise in less-common exchange scenarios like reverse exchanges and those involving Delaware Statutory Trusts. By using JTC as your QI and involving us in the planning process for your exchange as early as possible, you can prepare for unexpected hiccups and follow all IRS guidelines to keep your exchange on track.
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