Although the 1031 exchange can help you defer capital gains tax while enabling you to reinvest the proceeds from the initial investment into a new property, there are rules to guide each exchange. One of such rules is the 95% rule. So, what is the 95% rule in real estate?
What Is the 95% Rule in Real Estate?
The 95% rule is one of the guiding rules of the 1031 exchange. It states that a taxpayer can identify any number of properties, regardless of their values, provided the taxpayer acquires at least 95% of the total value of the properties identified.
Although the 95% rule offers more room to taxpayers to identify more properties than the three-property rule and the 200% rule, it allows you to forfeit only 5% of the total value of your identified properties. Therefore, it is essential to know the strengths and weaknesses of this rule and how you use them in your favor.
Advantages of Practicing the 95% Rule in a 1031 Exchange
Many might consider the 95% rule to be both a blessing and a curse, and without proper knowledge of what it entails, chances are it’ll be more of the latter. Still, here are some of the advantages of practicing this rule:
Ability to Identify an Unlimited Number of Properties
While carrying out a 1031 exchange, it is not unusual for investors to identify properties that they are unable to close on before the end of the 180-day stipulated period. If this happens, it could ruin the entire exchange. This is why it is safer to identify as many properties as possible than identify only a few.
With the rule, you can identify as many properties as you want, as opposed to the three-property rule, which limits your purchasing power by allowing you to identify only three properties, This way, you get to have an unlimited number of replacement properties, as long as you can close on 95% of their aggregate value.
Ability to Identify Properties of Unlimited Combined Values
While the 200% rule allows you to identify more than three properties, their total value must not exceed 200% -that is double- of the total market value of the relinquished property. However, the rule has no regard for property valuation.
This implies that you can choose properties whose combined values far exceed your relinquished property, thus allowing you to gain more for less.
Risks Involved in Practicing the 95% Rule
While the rule grants the most freedom to investors when it comes to the number of identified properties and the value of identified properties, it is not without risks. With this rule, you must acquire no less than 95% of the combined identified value within the stipulated exchange period, where the risk lies.
Here’s an example: if you sell (relinquish) a property with a value of $500,000, and you identify five properties with values of $500,000, $350,000, $700,000, $750,000 and $400,000, thus giving a combined value of $2,700,000. You will have to acquire at least 95% of this value, which equals $2,565,000.
In this case, the combined value of four properties out of the five must equal $2,565,000. If they do not, you may have to combine another set of properties or choose another replacement property to achieve an exact 95%. Failure to achieve this balance is tantamount to risking ruining the entire exchange.
How to Have a Successful 1031 Exchange in Northern Kentucky
In Northern Kentucky, taxpayers have 45 days to identify their preferred replacement properties. Within this period, they can modify already chosen properties by revoking previously identified- properties and identifying new ones. These property identifications, as well as the proceedings from the sale of the relinquished property, are then handed to a qualified intermediary(QI).
The 1031 exchange process is volatile, and things could quickly go wrong, even for experts. To avoid errors and successfully navigate the exchange, it is advisable to seek assistance from a professional local real estate agency such as Si Vales Valeo Real Estate.
Si Vales Valeo Real Estate will ensure all grounds are covered before the exchange, help you analyze ideal replacement properties, assist with closing all identified properties, and ultimately ensure a successful 1031 exchange.
What Properties Qualify for Identification in a 1031 Exchange?
According to the Internal Revenue Service, the following properties qualify to be exchanged in a 1031 exchange:
- Raw land or farmland for improved real estate
- Residential, commercial, industrial, or retail rental properties
- Oil & gas royalties for a ranch property
- Simple interest fees in real estate, for example, a 30-year leasehold or a Tenants-in-Common interest in real estate.
- Rental ski condo for a three-unit apartment building
- Mitigation credits for restoring wetlands for other mitigation credits
How Many Times Can You Use a 1031 Exchange?
No law limits the minimum or the maximum number of times a taxpayer is entitled to 1031 exchange or the frequency. A taxpayer is entitled to as many 1031 exchanges as possible, provided the taxpayer’s intent is qualified and all essential criteria are met.
The following are the IRS criteria regarding taxpayer’s intent:
- The purpose of initial property acquisition should only be for business or investment purposes
- Holding the replacement property should only be for business or investment purposes.
- The property’s tax history must demonstrate investment and/or business use.
In essence, the taxpayer’s intent must not be to make profits but rather hold for investment purposes. Failure to adhere to this criterion confers a dealer status to the taxpayer and may ultimately result in the IRS disqualifying the exchange.
The 95% rule offers taxpayers lots of freedom when identifying replacement properties, making it a great choice. However, remember to have a proper financial plan to avoid making a bigger purchase commitment than you can handle. You might also want to hire the services of an experienced real estate agent to walk you through the process.