Occasionally we receive a frantic call from an investor who is in the middle (sometimes at the end) of their 45-day identification period. Understanding the identification rules prior to entering a potential exchange may be the preferred path.
By Al DiNicola, AIF®, CEPA ™
June 9, 2023
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
The 1031 clock starts ticking upon the closing of the relinquished property. The 45 days are calendar days and no matter what day of the week the 45th day falls the identification period ends. Even if the 45th day is a weekend or holiday.
The investor (along with a financial advisor, real estate broker or other parties) will start evaluating potential replacement properties during the 45 days. One point to make clear is that during the 45 days the investor may change the properties on the 45-day list. Changes may be necessary especially if the intended replacement property is no longer suitable for the investor, is acquired by other investors or under other circumstances.
Without a QI, nothing else matters.
The qualified intermediary (QI) is a critical player in the exchange process. We cannot stress enough the importance of engaging a QI as soon as the investor has decided to sell the property referenced as the relinquished property. If the investor has sold the property without a QI being part of the transaction the exchange cannot be executed. Even if the title company is holding the sales proceeds in their escrow account. We would also strongly encourage language in the sales contract (of the relinquished property) to reflect the seller intends on executing a 1031 tax deferred exchange and the buyer shall not object to the process. Once the property is sold and the QI has received the proceeds of the sale the QI typically will send a form to the investor to fill out and send back to the QI. The IRS requires this form to be submitted to ensure that properties ultimately acquired were reflected on the form.
Identify by putting it in writing.
There are specific requirements set out in section 1031 regarding the acknowledgment or commitment to a certain list of potential replacement properties. The investor is referred to as the Exchanger and is required to submit a signed document to the QI. The QI is handling the details of the exchange sale. There are different acceptable methods of submitting the list to the QI. Some Exchangers may hand deliver the list. Other Exchangers will use email or fax to send the list. A text message is not a preferred method of communication. This list must be received by the QI by the end of the 45th day. We have worked with Exchangers who engaged with a QI on the west coast and have pushed the envelope so to speak with submissions. Best practices would encourage the Exchanger to have the final 45-day list submitted so that the QI may acknowledge receipt of the document.
If there is a change in the makeup of the list, we strongly encourage the Exchanger to send the new list with a notation that this current list supersedes or voids any previous list submitted on a previous date and list the previous document date. If there are a number of changes during the 45-days, the exchanger may want to title the list with a version number (v.1. v.2) and when the ultimate list is submitted mark the list FINAL.
ID Details matter.
Depending on the property the identification may be very easy or complicated. In the case of a single property there may be only one address and a tax identification number supplied by the property appraiser office. When purchasing land as a replacement property the legal descriptions may be more involved and have meets and bounds description. Clarity is the key for the identification. In the case of fractional ownership such as Tenants in Common (TIC) or a Delaware Statutory Trust (DST) many QIs (and the IRS) would prefer to have a percentage of ownership especially if not purchasing the entire property. Even in a partnership interest a full description and percentage of ownership is required to eliminate any confusion or challenge if there is an IRS audit on the exchange.
Reviewing the financial requirements
As a brief review of the financial requirements the Exchanger needs to :
- Replace the relinquished property with equal or greater value
- Replace any debt that was paid off on the relinquished property.
- Use all the cash the QI is holding.
Let’s review the rules for identifying properties.
The first rule (and potentially most often used) is the Three Property Rule.
This may be the simplest of the rules for filling out the list. You may identify three properties no matter what the fair market value may be. For example, if your relinquished property was sold for $500,000 you may identify three properties with a total value of $1,500,000.
If you have identified three properties that were less than the replacement price you may acquire more than one property. If buying only one property, the other identified property will be back-ups if for some reason the first property falls through.
Potential greater flexibility with the 200% Rule
The 200% rule can be confusing at times when attempting to calculate the values. In simple terms you may identify as many properties as you want, as long as the total value does not exceed 200% of the fair market value of your relinquished property. What complicates this to a certain degree would be that the identified properties will include the total acquisition price including any debt that is being replaced. If we use the same $500,000 in the example above and if it is an all-cash transaction you may list as many properties as you want up to a total of $1 M. If you are financing part of the replacement properties, you will need to evaluate the specific LTVs on each property and then identify as a total price.
Seldom used 95% Identification Rule
In all our years of dealing with 1031 exchanges (including DST replacement) we have not seen any investor utilize the 95% Rule. This enables an investor to identify as many properties as they wish regardless of value, as long as they purchase 95% of all properties identified. Anything less would jeopardize the exchange.
The first step to a successful exchange may start with hiring the right Qualified intermediary (or accommodator). While the cost may vary a few hundred dollars, you want an experienced QI. Understanding your replacement options prior to entering into an exchange is an important step. Each of the rules has positives and drawbacks.
Delaware Statutory Trust (DST) has provided a solution for many investors who become exchangers. The DST options provide for diversification of replacement properties and can satisfy debt replacement with non-recourse debt. There is also flexibility in balancing the debt with certain DST properties enabling the exchanger to potentially spread risk out over a diversified portfolio of properties. The same $500,000 property example from above may enable an investor to invest in a DST portfolio of three to four properties with different asset classes as well as geographic diversification.
We opened this article with a frantic call from investors who were in the middle or end of their 45-day identification period. We have successfully assisted investor/exchanger who had only two days remaining in their identification period. While this is not the preferred timing, we have access to a wide variety of DST replacement properties. Investor who have spent time reviewing the DST alternative can make a decision on moving forward.
Contact us for additional information on the DST structure and function for your potential investment solutions.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email email@example.com.
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NAMCOA® – Naples Asset Management Company®, LLC