45-Day Identification Rule: 1031 Exchange Series Part Three
If you’ve been following along with our seven-part series on 1031 exchange basics, you’ve already learned about the six basic requirements. We’ve already discussed the requirement of the property being held for investment in part two. Now, in part three, we will discuss the second requirement of a 1031 exchange which is the 45-day identification rule. Continue reading on to understand what the rule is and why it’s important.
The 45-Day Identification Rule
There are two very critical timing requirements when completing a 1031 exchange. This first is the 45-day identification rule and the second is the 180-day rule, which we will discuss in part four of this series. The 45-day identification rule is relatively straightforward. This states that you have 45 days from the date of closing your sale in order to identify your potential replacement properties. Before you begin to panic, this doesn’t mean closing on them or getting them under contract. It simply calls for you to identify them.
While 45 days seems like a lot of time before you sell, once people close, they tend to go into panic mode. Don’t let this happen to you! Our best recommendation is to start the search for your replacement property well before you close your sale. It’s important to note that day one starts on the date of your closing. You then have to the end of 45 calendar days to do one of two things:
- Identify the replacement properties and take title to it OR
- Produce a written list of the replacement properties that you’re going to use
If you decide to go with the second of the two options, you must actually write the list and it needs to be a specific identification. For example, you can’t just write down, “I want to buy a unit in the Carrollwood condos”. Rather, you’ll need to be more specific by saying, “I want to buy (or I’m thinking of buying) 4352 Unit C in the Carrollwood condominiums”.
Narrowing Down the List
The list of potential properties you need to create within 45 days is very important. Therefore, it’s critical that you get on top of it right away. Only the property that is on that list will qualify to finish your 1031 exchange. Now, your first thought might be to just load up your list with twenty or thirty properties. It makes sense but the IRS has anticipated this and placed limits upon it. The IRS creates a sort of three-part funnel where they try to make you be very specific and limit the number of properties that you identify for your exchange. This part can get a little tricky, so we’re going to break it down further.
First Part of the 45-Day Identification Rule
The first part of the 45-day identification rule states that as long as you name three or fewer properties in your list, it doesn’t matter how much they’re worth. For instance, if you sell a small condo for $100,000, you could name three $5 million-dollar offices on your list and it would be fine. Of course, you might have a little trouble closing on those if all you’re selling is a $100,000 condo. However, you are still able to do it.
Second Part of the 45-Day Identification Rule
Now, the second part of the 45-day identification rule covers what happens when you list more than three properties. In this situation, the total value of that list can be no more than 200% of the value of what you sold. If we go back to our last example with the $100,000 condo, you would be able to list four replacement properties worth $50,000 each. That’s because $50,000 x 4 = $200,000 which is 200% of the original sale of $100,000. You cannot go over this limit. If you tried to list three of those $50,000 properties and then a $75,000 one, you would be over the limit and it would disqualify your entire exchange.
In order to make this just a bit more confusing, there is one more exception to listing more than three properties. If those four or more properties have to be more than 200% of the value of what you sold, you can still do it; but only if you actually closed on 95% of the value of your list. This is the trickiest part of IRS law and can be perplexing to try and understand, even for professionals.
If we go back to our example of selling a condo for $100,000 and listing four replacement properties. Consider if on this list there are three $50,000 lots and one $75,000 lot. So, more than three are named and the total of the four is more than 200% of what you sold. HOWEVER, if you closed on all four of those lots, then you would have closed on 95% of the value of the list. Therefore, you are able to do that.
There are No Extensions and No Exceptions
It’s in your best interest to keep this process simple and quick. 45 days can go by very quickly and the IRS does not offer any individual extensions or exceptions. Once the 45 days have passed, whatever is on that list are the only properties you can choose from. It doesn't matter if you get outbid on one, another burns down, and the owner of the other one dies and it goes into probate, those are the properties the IRS says you can purchase. There are no individual extensions and no exceptions. This is where most 1031 exchanges usually fail, therefore it’s important to take it seriously.
We’ll offer one last example to make sure you completely understand the 45-day identification rule.
Billy and Jane have sold their rental property for $100,000. They want to identify two or three $1,000,000 replacements. Can they do that? The answer is yes because they only named three or fewer potential properties.
However, what if Bill and Jane sell that same property for $100,000 and they want to identify four little condos for $75,000 each. Can they do that? Well, the answer is maybe. Although it does break the 200% rule, as long as they closed on all four of those, they would have closed on 95% of the list. Therefore, that would qualify under the IRS 45-day requirements.
The best advice we can offer is to start looking for properties before you close. Don’t take too long to get started. We offer a convenient 1031 Exchange Timeline Calculator that will help you with the 45-day identification rule as well as the upcoming 180-day rule. We highly recommend you bookmark this page and use it whenever you’re planning your 1031 exchange.