The Golden Rule of Real Estate Investing: Replacement Property Requirements for 1031 Exchanges

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Author: Matthew Riley

PART 2 – The exchanger must intend to hold the replacement property (acquired property) for productive use in a trade or business or for investment purposes.

In Part 1 of this blog series about 1031 like-kind exchanges, we discussed a real estate investor’s relinquished property (the property an investor is selling), and the requirements such property must meet under Section 1031 to qualify for a like-kind exchange.

If an exchanger’s relinquished property meets Section 1031 requirements, then the next set of questions involve the replacement property, which we discuss, here, in Part 2.

One central inquiry is to investigate the exchanger’s intention in acquiring and using the replacement property.  For an exchange to receive tax-deferred treatment, the exchanger must intend to predominantly use the replacement property in furtherance of a trade or business, or as investment property.

Many of the same issues raised in Part 1 about relinquished properties are the same for replacement properties.  Therefore, our discussion about how requisite intent for relinquished property also applies for replacement property.

Here, in Part 2, I will focus attention on particular holding requirements for replacement properties, highlighting two things:

First, a safe-harbor provision for a specific and common type of replacement property––secondary and vacation homes; and secondly, specific requirements unique to replacement property, which the exchanger must meet when selecting such properties.

(a)      Safe Harbor for replacement properties the exchanger intends to use as a second residence or vacation home?

The safe-harbor requirements for secondary residences or vacation homes are the same as I articulated for relinquished secondary or vacation homes. See Part 1.1. For these types of property, Revenue Procedure 2008-16 provides that if the exchanger meets its requirements it has established the requisite intent for the replacement property.

Under the safe-harbor requirements, the exchanger must own the home for two years immediately after the exchange, and for each of those years, or 12-month periods, the Exchanger must both:

(1) Rent the unit at a fair market rate for 14 or more days; AND

(2) Restrict their personal use to the greater of 14 days – OR – 10% of the number of days it was rented at a fair market rate within that 12 month period.

An investor must follow these requirements to defer their taxes under Section 1031.

(b)      Special rules for selecting and obtaining replacement property?

In general, under Treasury Regulation 1.1031(k)-1(b)-(e) the exchanger must receive the replacement property within 180 calendar days after the relinquished property is transferred, or on the date the Exchanger’s tax returns are due for the relinquished property, whichever is earlier. This is termed the “Like-Kind Exchange Period”.

Within this 180-day period, the exchanger must follow special rules and restrictions as they select replacement properties in a like-kind exchange.  These rules relate to timing constraints within which a replacement property must be identified, as well as rules providing the exchanger greater flexibility in making a final determination about which replacement property they wish to acquire.

(1)     Identification Period (45 days)

Section 1031(a)(3) establishes a timeframe during which the exchanger must identify the replacement property for a like-kind exchange.  The start of this period is triggered by the transfer of any relinquished property from the exchanger. Once the exchanger relinquishes a property, they have 45 days to identify the replacement property they wish to acquire.

During this 45-day period, the investor can meet the identification requirements in one of two ways:

[i]      The exchanger purchases the replacement property within this period, thereby consummating and finalizing the like-kind exchange;

OR

[ii]     The exchanger composes and delivers a signed “Identification Notice” within 45-days to a qualified intermediary or permissible party in the exchange, such as the seller of the replacement property. The identification notice must include a specific and unambiguous description of the replacement property, such as the properties legal description, street address, or a distinguishable name if there is one (e.g. Waterview Hotel).

Replacement properties that include incidental properties that are typically transferred with the larger property and are valued less than 15% of the replacement properties’ total purchase price need not be separately identified by the Exchanger.  An example of incidental property may be desks in an office building.

(2)     Multiple and Alternative Replacement Properties

During the 45-day identification period outlined above, the exchanger is not required to finalize a decision on which replacement property or properties they will ultimately acquire.  By following one of the three methods below, the exchanger can create a short list of potential replacement properties from which they can later choose.

[i]      Three Property Rule – The exchanger can choose any three properties regardless of each individual property’s fair market value;

[ii]     200% Rule – The exchanger can choose as many potential replacement properties provided that the aggregate fair market value of all identified properties is not greater than 200% of the relinquished property;

[iii]    95% Exception – If the Exchanger does not fit under either of the two above rules, then he or she is required to acquire property worth at least 95% of the aggregate fair market value of all the identified replacement properties by the end of the “Like-Kind Exchange Period”.

Here is a table of contents of our Section 1031 Exchange Articles:

INTRODUCTION – GOLDEN RULE TO REAL ESTATE INVESTMENT

PART 1 – THE RELINQUISHED PROPERTY (SOLD PROPERTY) MUST HAVE BEEN HELD BY THE EXCHANGER FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMEST PURPOSES.

PART 2 – THE EXCHANGER MUST INTEND TO HOLD THE REPLACEMENT PROPERTY (ACQUIRED PROPERTY) FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMENT PURPOSES. 

PART 3 – BOTH THE RELINQUISHED AND REPLACEMENT PROPERTY MUST HAVE A NATURE AND CHARACTER THAT IS “LIKE-KIND” WITH THE OTHER.

 

photo credit: ottawaarchitects150 MacDonald Manor, Samuel A. Gitterman Architect via photopin (license)