The 1031 exchange is a process that enables owners of real estate properties to defer capital gains tax during the sale of one property to buy another one of the same kind. This exchange comes with many rules, one of which is the 200% identification rule. What is the 200% identification rule in a 1031 tax-deferred permit?
What Is the 200% Identification Rule in a 1031 Tax-Deferred Permit?
The 200% identification rule is perhaps the most common option for exchanging commercial properties under the 1031 exchange. According to this rule, a taxpayer can identify an unlimited number of replacement properties as long as their aggregate fair market value does not exceed 200% of the value of the relinquished original property.
In simpler terms, the 200% rule allows you to identify as many potential replacement properties as you want, provided their combined value doesn’t exceed 200% of the aggregate fair market value of all relinquished property’s value. This rule is best for investors who are looking at identifying replacement properties that exceed 3, as opposed to the dictates of the 3-property rule which is an identification rule.
Aside from the 200% rule, the 1031 exchange has some other identification rules that have to be followed to ensure a successful exchange. They are:
- The 45 days time limit to identify replacement property
- The 3-property rule
- The 95% rule, which comes right after the 200% rule
- The incidental property rule
- Description of new Replacement Property (including street address and unit number if applicable)
- Property to be reconstructed
This applies to all areas including the Cincinnati and Northern Kentucky area. You would also need a qualified intermediary for this transaction.
Advantages of Practicing the 200% Identification Rule
Identifying suitable replacement properties is a vital decision for commercial real estate investors. Choosing the right properties can ensure a smooth 1031 exchange. Choosing the wrong investment property that are unable to close within the 180-day timeframe can hinder the 1031 exchange from being a smooth and successful execution.
This is where the 200% identification rule comes in. Here are a couple of advantages that the rule offers:
Ability to Identify More Than Three Properties
This can be a complex transaction and because of the risks that come with properties identified that they cannot close on, investors would rather want to identify as many properties as possible than identify only a few. The 200% rule gives investors an edge over the three-property rule which states that taxpayers can formally identify only up to three properties of any value.
The value of the identified properties must not exceed twice the sale price or the value of the property sold before investors are allowed to exchange. This way, if your first properly identified exchange property or even your second as well do not make it to closing within 180 days, the other chosen properties most likely will by the closing date. Hence, you reduce the chances of having an unsuccessful 1031 exchange by identifying the fair market value and taxpayer acquires property.
No Minimum Criteria for Acquiring Properties
Another 1031 exchange identification rule that enables the person involved to formally identify as many properties as they want including up to four or more properties is the 95% rule. However, this rule has a clause that you might find very restricting. It allows you to identify an unlimited amount of replacement properties, provided they are worth 95% or more of the total value.
This means that you can only forfeit properties valued at 5% of the combined value of identified properties, whereas, with the 200% rule, you are allowed to forfeit any number of chosen ideal replacement properties if you cannot close on them within the given time including your first identified property. Hence, one less restriction with the 200% rule.
While identifying replacement options, it is advisable to hire the help of a professional real estate agent, such as Si Vales Valeo Real Estate. Not only will they provide ideal replacement investments, but they would also see to a smooth exchange period including transfer and closing, hence ensuring the success of your 1031 exchange. Properties are typically transferred quite rapidly.
Example of Using the 200% Rule
Here is an illustration of how the 200% rule is used.
Two investment partners have decided to sell their fast-food restaurant due to varying business goals and expectations. After the additional property listings is sold and all escrow accounts are closed, they are left with $1.5 million to invest in a 1031 exchange.
Partner A wants to acquire a $1 million clothing store, while partner B wants to purchase a $900,000 coffee shop. When both properties are identified on the 45-Day form for a total of $1.9 million, they decide to use the 200% rule. This allows both partners to acquire additional properties worth $1.1 million, bringing the total fair market value of properties identified to $3 million. This value does not exceed 200% of the value of the relinquished property of $1.5 million.
Both partners concede to put the remaining $1.1 million from the exchange into purchasing the following properties:
- A multi-family apartment worth $600,000
- A cold-storage warehouse worth $200,000
- A dollar store worth $300,000
How to Identify Replacement Properties
When investors want to acquire replacement property, it is always best for the properties whether multifamily properties or otherwise to be identified immediately and within the 45-day Identification period to avoid/defer capital gains taxes and enjoy taxpayer transfers on the relinquished property or primary property sale.
However, a previously chosen property can be substituted for a new property as long as it is done within the specified 45-day identification period. This way, investors can still identify more than three potential replacement property and boost investment portfolio.
For investors seeking interests less than 100%, they are required to indicate the percentage of ownership rights with a detailed legal description of the real property, usually on a written document.
Determining if Using the 200% Rule is the Right Choice
Before investors decide to follow the 200% rule, they need to determine if it is the right choice for them to facilitate a smooth and successful 1031 exchange and avoid becoming a disqualified person.
To do this, commercial investors should decide on what number of relinquished commercial real estate properties they intend to identify for the 1031 exchange. If they would like to identify more than three like kind replacement properties, then the 200% rule is the right choice for them.
Disadvantages of Practicing the 200% Identification Rule
Although practicing the 1031 exchange 200% rule offers advantages, there are a few disadvantages commercial real estate investors should be aware of and understand. These disadvantages are as follows:
Increased Planning and Coordination
When practicing the 1031 exchange 200% rule, real estate investors are required to implement extra planning and coordination procedures to ensure that they don’t go over the 200% threshold of all the properties and the exchange is successful.
The IRS is typically strict regarding 1031 exchange rules. Therefore, the exchange will not be approved if the aggregate fair market price of the identified replacement properties exceeds 200%, even by the slightest margin.
Pressure Due to Time Limit
Unlike the 3 property rule that only allows for up to three properties, investors are permitted to identify more than three properties, provided the criteria for approval are met.
This may put some more pressure on investors, as failure to identify replacement properties with a combined fair market value of not more than 200% within the standard 45-day identification period may result in them incurring taxes on the sale of the relinquished property.
Limited Replacement Property Options
The 200% states that the investor may acquire as many properties as possible. However, the truth is that investors are often limited regarding the type and number of replacement properties. This limitation is caused by budget and combined market price regulations.
What Are the Reasons an Investor Might Consider Using a 1031 Exchange?
The main advantage of a 1031 exchange, as opposed to the traditional selling and buying of properties, is the provision it makes for investors to defer the payment of taxes. Aside from tax deferral, however, here are other reasons that should make you consider using the 1031 exchange rule:
- It helps you to diversify assets. For example, if you own one apartment complex, you could choose to sell it to acquire more apartment complexes, hence helping you to build an impressive commercial real estate portfolio.
- It helps you to acquire properties that might offer higher returns
- It allows you to avoid paying a higher tax on a property, as a result of depreciation recapture.
How Many Properties Can I Identify in a 1031 Exchange?
The number of properties you can identify while carrying out a 1031 exchange depends on the identification rule that you choose to follow. The 200% rule, for instance, allows you to identify as many properties as you want as long as their total value does not exceed 20% of the value of your sold property.
How Long Does a Property Need to Be Held Before Doing an Exchange?
According to the tax code, there is no stipulated period for which an investor has to hold a property before replacing it using a 1031 exchange. However, a one-year hold period has been proposed by the government many times. To be on the safe side, it is best to have held the property for a year or more.
The 1031 tax-deferred exchange is a great opportunity for investors to acquire more properties for less. However, the process might be quite complex, especially for an investor acting alone, which implies hiring the services of professionals is a must. Si Vales Valeo Real Estate will be by your side throughout the 1031 exchange process and see it to a successful end.