Identification Rules for a 1031 Exchange

Section 1031 is an IRS code section that lets you defer tax (in some cases a lot of tax), but of course they don't make the deferral easy. But it's not impossible either.

One of the rules that can cause a lot of angst, especially in a fast-moving real estate market like the one we have now, is the requirement that you identify a list of new properties you might want to buy within 45 calendar days of the closing of your Old Property. Whatever you buy to complete your exchange must be on this list. The identification is made on a form provided to you by your QI, your Qualified Intermediary (the 1031 specialist the law requires you to use to guide you through this process).

The identification period is calendar days and begins on the date your sale closes. It includes weekends and holidays, which means if your 45th day falls on the 4th of July, your identification must be received by your Intermediary by midnight of that date. Emailing is the customary method of transmitting your form to the Intermediary.

The rules allow you to identify up to three properties without limitation. If you wish to identify more than three properties, the IRS rules narrow and become tougher. Way tougher. If you identify four or more properties, the sum of the purchase price of all four-or-more properties on your list cannot exceed twice the sales price of your Old Property. For example, if you sell your Old Property for $100,000, and list four potential replacement properties, the combined purchase price of all four properties cannot exceed $200,000. Had you listed only three properties, the combined purchase price of all three could have been $20 million or more, because there's no limit to the value of the replacement properties if your list has only three replacement properties or less.

The properties you list are properties you might want to buy. You are not required to buy all of them, but you are required to buy at least one of them to complete your exchange. You can change the list as many times as you like until midnight of the 45th day — at which point the gate slams shut and the properties on your list are cast in concrete. What if a property you list is no longer available? — which is a real possibility in today's fast-moving market. The answer depends on where you are within the 45-day limit.

If you still have days left, you can submit a new list, removing the unavailable property and replacing it with one that is available. So for example, if it's day 30 of your 45-day period, and one of your three listed properties just sold, you can remove that property from your list and replace it with another property. However, if you're beyond the 45th day, your list is unchangeable, which means you only have two properties left (assuming that you listed three properties to begin with). The 45 days are cast in stone.

So how do you deal with this in such a fast-moving market? My advice to our clients is to start as soon as you list your property for sale. As soon as the listing process is complete, you should start immediately looking for possible replacement property. Start looking for properties in your price range in your target neighborhoods. Decide immediately where you want to buy and what your options are within that area. Then keep an eye on that area to get a sense for how long things stay on the market before they sell, and what the true market prices are. As soon as your property goes under contract, you want to get serious about making an offer.

Zero in on your choice property and get it under contract. Set the closing date for three weeks after the contracted closing date of your Old Property. Why three weeks? Because three weeks is half-way through the 45-day identification period. If you can close your purchase during those 45 days, you won't have to make a list at all (because the closing "identifies" the property you want to buy). Three weeks also gives you some flexibility if the closing of the sale of your Old Property gets delayed, and also gives you time to find another property if the closing your first choice falls through.

Although the rules can be restrictive, they're easy to work with if you have a good plan — which is really critical in the fast-moving market we have right now.