1031 Exchange - Property Identification

The identification process is the step where the taxpayer identifies his or her potential replacement properties that are being considered for acquisition. This is only an identification requirement and the properties do not need to be under contract or in escrow.

There are strict requirements regarding identification of replacement property. These requirements must be met before the expiration of 45 days from the date the relinquished property is sold. Identification of all replacement property must be made in writing, must be signed by the taxpayer, and must be delivered to the qualified intermediary on or before the 45th day. The identified properties must be unambiguously identified by the property address, or the legal description, or the Assessor's Parcel Number, or all three.

There are three rules that limit the identification of replacement properties. The taxpayer must meet the requirements of at least one of these rules:

A. Three-Property Rule: Identification of alternative replacement properties is valid if the taxpayer identifies no more than three alternative replacement properties as part of the same deferred exchange, regardless of the values of the relinquished or replacement properties.

B. 200 Percent Rule: When the taxpayer identifies more than three alternative replacement properties in connection with the same deferred exchange, the identification is valid as long as the aggregate fair market value of all replacement properties at the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties in the exchange on the date or dates on which the taxpayer transferred the relinquished properties.

C. 95 Percent Rule: A perfectly valid exchange could involve a taxpayer transferring a single relinquished property and acquiring more than three replacement properties whose aggregate value exceeds 200 percent of the value of the relinquished property. The drafters of the deferred exchange regulations recognized that some taxpayers might want to complete such exchanges as deferred exchanges and should be allowed to do so. Accordingly, the 95 percent rule was adopted as a safety valve. Identification of alternative replacement properties is valid even if the taxpayer fails to meet either the three-property rule or the 200 percent rule, as long as the taxpayer receives at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period. It should be noted, however, that if the taxpayer fails to acquire at least 95% of the value of the properties identified, his or her entire 1031 exchange transaction will be disallowed.

We recommend that the taxpayer follow the 3-property rule, and identify either two or three properties, so that if the closing on the preferred property fails for any reason, the taxpayer will have made a timely identification of one or two alternate properties which may be acquired instead. The identification rules and requirements each have certain benefits and certain risks involved, so care should be taken to consult with a competent legal, tax and/or financial advisor before completing your identification of replacement properties.