Like-kind property is defined according to its nature or characteristics, not its quality or grade. This means that there is a broad range of exchangeable real properties. Vacant land can be exchanged for a commercial building, for example, or industrial property can be exchanged for residential. But you can’t exchange real estate for artwork, for example, since that does not meet the definition of like-kind. The property must be held for investment though, not resale or personal use. This usually implies a minimum of two years’ ownership.
To receive the full benefit of a 1031 exchange, your replacement property should be of equal or greater value. So you should expect to pay taxes on any elements that are not replaced (the Boot).
You must identify a replacement property for the assets sold within 45 days and then conclude the exchange within 180 days. There are three rules that can be applied to define identification.
In addition to the timelines which are important in the 1031 process, there are some rules regarding the identification process that should be followed. As a rule, surrounding these rules, you will only be required to follow one of the below situations:
The 3-Property Rule
The 3-property rule states that the replacement property identification during the initial 45 days of the exchange can be made for up to three properties regardless of their total value.
So after the investor relinquishes their initial property, the taxpayer can identify and purchase up to three replacement properties that may suit their investment appetite going forward.
A qualified intermediary often requires that a taxpayer state how many replacement properties they intend to acquire to prevent common pitfalls surrounding the receipt of excess funds and the early release of funds.
The 200% Rule
If a taxpayer were to identify more than three properties, they could still have a valid exchange by following the 200% rule. The 200% rule states that a taxpayer may identify and close on numerous properties, so long as their combined fair market value does not exceed double the value of their relinquished property.
Using the listing price is usually a safe way of determining a fair market value for a property.
The 95% Rule
If the taxpayer has overidentified both of the previous rules by identifying more than three properties, and their combined value being more than 200% of the relinquished property value, the 95% value comes into play. The 95% rule defines that identification can still be considered valid after breaking the first two rules if the taxpayer purchases through the exchange at least 95% of what they identified.
Keep the rules in mind and consult your Certified Financial Planner® and Exchange Manager for details regarding your exchange.