What Is the 45-Day Identification Rule in a 1031 Exchange?

In a deferred 1031 exchange, an investor generally has two major deadlines:

• 45 days to identify replacement property
• 180 days to complete the acquisition of the replacement property

The identification period begins when the investor transfers the relinquished property.

The IRS requires replacement property to be identified within 45 days after the transfer of the relinquished property. The replacement property generally must then be acquired by whichever of these two dates comes first:

• The 180th day after the relinquished property is transferred
• The due date, including extensions, of the investor’s federal income tax return for the tax year in which the property was transferred

This second requirement can become particularly important for exchanges beginning late in the calendar year. Investors should coordinate with their tax professional regarding whether a tax return extension may be necessary to preserve the full exchange period.

The 45-day identification deadline is one of the most important dates in the exchange process because it generally cannot simply be extended because an investor has not found suitable replacement property.

That is why replacement-property planning should ideally begin before the relinquished property closes, not after the 45-day clock has already started.

How Do You Identify Replacement Property in a 1031 Exchange?

The identification generally must be made in a signed written document and delivered to the appropriate party involved in the exchange, such as the qualified intermediary.

The replacement property also needs to be clearly described. For real estate, the IRS notes that a legal description or street address may be used to clearly identify the property.

Investors can change or revoke an identification during the 45-day identification period if the required procedures are followed. Once the identification period expires, however, the investor generally cannot simply replace an identified property with a different investment.

This makes the identification strategy itself an important part of planning a 1031 exchange.

What Is the 3-Property Rule?

The 3-Property Rule is the identification method used in many 1031 exchanges.

Under this rule, an investor may identify up to three potential replacement properties without regard to their fair market value.

Do You Have to Buy All Three Properties?

No.

The 3-Property Rule allows the investor to identify up to three potential properties. The investor does not necessarily have to acquire all three.

An investor might identify a preferred replacement property along with one or two alternatives in case the first transaction falls apart during due diligence, financing or negotiations.

Alternatively, an investor may intend to purchase two or three identified properties as part of a diversified replacement-property strategy.

The important distinction is that the identification rules determine which properties remain eligible to be acquired through the exchange. They do not necessarily require the investor to purchase every property identified.

What Is the 200% Rule?

The 200% Rule becomes important when an investor wants to identify more than three replacement properties.

Under the rule, an investor may identify any number of potential replacement properties as long as their combined fair market value does not exceed 200% of the aggregate fair market value of the relinquished property or properties.

For example: an investor sells a property for $2 million. Two hundred percent of the relinquished property’s value is $2 million x 200% = $4 million.

The investor could therefore identify four, five or potentially more replacement properties as long as the combined fair market value of all identified properties does not exceed approximately $4 million.

Example of the 200% Rule

What Is the 95% Rule?

The 95% Rule is often misunderstood.

Unlike the 3-Property Rule and 200% Rule, it generally should not be viewed as the preferred identification strategy for most investors.

The 95% Rule can potentially preserve an exchange when an investor identifies more properties than permitted under the 3-Property or 200% Rules, but only if the investor ultimately acquires qualifying identified replacement property representing at least 95% of the total fair market value of all identified replacement properties.

That is an extremely high threshold.

Example of the 95% Rule

Because the investor must acquire nearly everything identified, the 95% Rule leaves very little room for a property to fall out of escrow, fail due diligence or otherwise become unavailable.

For that reason, investors generally should not intentionally rely on the 95% Rule without discussing the strategy carefully with their qualified intermediary and tax advisors.

3-Property Rule vs. 200% Rule vs. 95% Rule

The easiest way to understand the three rules is:

For most investors, the planning discussion begins with the 3-Property Rule or 200% Rule rather than the 95% Rule.

How the Identification Rules Affect DST Investors

The identification process can become particularly important when investors use Delaware Statutory Trusts, or DSTs, as 1031 replacement property.

A DST can allow an investor to acquire a fractional beneficial interest in institutional-quality real estate rather than purchasing an entire property individually.

DSTs may be considered as part of a replacement-property strategy for investors seeking objectives such as:

• Passive ownership
• Diversification
• Replacement of exchange equity
• Potential replacement of relinquished-property debt
• Reduced management responsibilities
• Access to different property types and geographic markets

An investor might use a DST as their primary replacement-property strategy, combine multiple DST interests or use a DST alongside directly owned real estate. For a closer look at how DSTs compare with buying property outright, see DST vs. Direct Real Estate: Which Is Better for a 1031 Exchange?

However, the same identification deadlines remain important.

If DST interests are being used in an exchange, investors should work with their qualified intermediary and professional advisors to make sure the identification documentation properly describes the replacement interests being considered.

Availability also matters. DST offerings can raise capital and close to new investors, which is another reason investors should avoid waiting until the final days of the identification period to develop their replacement-property strategy.

New to DSTs? Access our free DST Investor Guide to learn about 1031 exchanges, DSTs, 721 UPREIT strategies and more before your exchange begins.

What Happens If You Identify Too Many Properties?

This is where the identification rules become particularly important.

If an investor identifies more properties than permitted under the 3-Property Rule and also exceeds the 200% limitation, the IRS generally treats the investor as though no replacement property was properly identified, subject to limited exceptions that include the 95% Rule.

That can place the tax-deferred status of the exchange at risk.

Investors therefore should not think of the identification sheet as simply a list of every property they might possibly consider.

The number of properties identified and their respective values should be reviewed before the identification is finalized.

Common 1031 Exchange Identification Mistakes

Several problems can arise during the identification period.

Can You Identify More Than Three Properties in a 1031 Exchange?

Yes. This is one of the most common questions about 1031 exchange identification. An investor is not automatically limited to three replacement properties.

An investor can generally choose between two paths:

• Identify up to three properties under the 3-Property Rule, regardless of their value
• Identify more than three properties under the 200% Rule if their combined value does not exceed 200% of the relinquished property’s value

The 95% Rule provides a much narrower exception if those limitations are exceeded.

Do You Have to Identify the Property You Eventually Purchase?

Generally, yes. The replacement property ultimately acquired through a deferred exchange generally needs to be property that was properly identified during the identification period, although property actually received during the identification period is treated as identified.

After Day 45, investors generally cannot decide that they prefer an entirely different property and simply substitute it for one on the identification.

When Should You Start Looking for 1031 Replacement Property?

Ideally, before the relinquished property closes.

One of the biggest misconceptions about a 1031 exchange is that the investor has 45 days to begin deciding what to do next.

Technically, the identification period begins after the relinquished property transfers. Strategically, however, that should not necessarily be when replacement-property planning begins.

Before closing, investors can begin considering questions such as:

• Do I want to continue actively managing real estate?
• Do I want one replacement property or multiple investments?
• How much debt must I replace?
• How important is current income?
• Am I comfortable taking additional financing?
• Should I diversify across markets or property types?
• Would directly owned real estate, DSTs or a combination make sense?
• What is my expected investment time horizon?
• What do I ultimately want to accomplish after this exchange?

Answering those questions early can make the 45-day identification period significantly more manageable.