This article lays out the time limitations and related restrictions in a delayed exchange for the identification and acquisition of replacement property.

Identification and acquisition periods

An investor opens an escrow for the sale of his investment property. The property sold is either a rental property or land held for profit on eventual resale.

The investor will not purchase replacement property with his net proceeds on the close of his sales escrow. However, he does expect to avoid profit reporting under §1031 by ultimately purchasing replacement property with the net proceeds.

Since the replacement property will be purchased later, the investor is involved in a delayed §1031 transaction, called a deferred exchange by the IRS. However, instead of actually exchanging properties, he is selling one property now and buying another later in two mutually exclusive cash transactions.

The buyer of the property being sold agrees to cooperate in a §1031 exchange under a provision in the purchase agreement. [See first tuesday Form 150 §11.10]

Prior to closing the sales escrow, escrow is instructed by the investor to deposit the investor’s net sales proceeds into a §1031 trust to be managed by a trustee, also called an accommodator or facilitator.

The investor’s closing statement on the sale will indicate the investor received Exchange Valuation Credits (EVCs) for his net equity, in lieu of the cash sales proceeds originally agreed to with the buyer.

The EVCs are contract rights allowing the investor to use the funds held by the §1031 trustee to fund the purchase of replacement property. The purchase of the replacement property is negotiated, contracted for and escrowed by the investor. The trustee is uninvolved, except to hold the funds until the investor calls for them to be deposited to his account in the replacement property purchase escrow. On closing and on the investor’s demand, the trustee will fund the investor’s purchase escrow. Thus, the investor’s §1031 reinvestment plan will be completed.

However, the investor processing a delayed §1031 reinvestment transaction must:

  • identify in writing the prospective replacement property(ies) within 45 days after the close of the sales escrow on the property he sold; and
  • acquire ownership of the (identified) replacement properties (by closing the purchase escrow) within 180 days after the close of the sales escrow, unless the due date for the investor’s tax return, including extensions, for the year of the sale of his property occurs earlier. [Internal Revenue Code §1031(a)(3)]

The 180-day acquisition period includes the 45-day identification period. Both commence on the day escrow closes on the property sold.

If two or more properties are being sold and consolidated into one replacement property by an individual, the periods for identification and acquisition of the replacement property begin to run from the closing date of the first property to sell. [Revenue Regulations §1.1031(k)-1(b)(2)(iii)]

Should the owner fail to meet either the identification or acquisition deadline, the property acquired does not qualify as replacement property. Thus, the profit in the properties sold would not be exempt from taxes under §1031. [Rev. Regs. §1.1031(k)-1(a)]

Identification period

An investor in a delayed §1031 transaction must, in writing, identify the replacement property by midnight on the 45th day after the date the sales escrow closed on the property sold. [Rev. Regs. §1.1031(k)-1(b)]

For example, an investor intends to complete a §1031 transaction. Escrow for the sale of the investor’s property closes on November 16. The last day for the investor to identify replacement property is December 31 – 45 days after the date escrow closed on the sale.

If ownership to any §1031 replacement property is acquired within the 45-day identification period, the replacement property acquired is treated as identified without further documentation. [Rev. Regs. §1.1031(k)-1(c)]

Thus, an investor entirely avoids the identification process by closing the purchase escrow on all replacement properties within the 45-day identification period.

When ownership of any replacement property will be acquired after the 45-day identification period, the investor must sign and deliver a written §1031 property identification statement within the 45-day period. The form must be delivered to either:

  • the person who is conveying (selling) the replacement property to the taxpayer; or
  • any person involved in the §1031 transaction, except the investor or persons who are disqualified. [Rev. Regs. §1.1031(k)-1(c)(2); See Form 360, accompanying this chapter]

Persons to whom the identification statement may be delivered include the escrow agent or title company involved in the sale of the investor’s property.

Persons disqualified to receive the identification

Consider a real estate broker who lists investment real estate for sale. The sale of the listed property is intended by the seller to be part of a §1031 reinvestment plan.

The broker has acted as the investor’s agent in real estate transactions during the preceding year. However, all listings and sales have been handled on behalf of the investor as §1031 transactions.

Is the real estate broker a disqualified person for purposes of receiving the identification statement?

No! A disqualified person includes only those real estate brokers, attorneys, employees, accountants and investment bankers who, within two years prior to the closing of escrow on the property sold, performed any professional services which were not part of a §1031 transaction. In other words, brokers, attorneys and CPAs who hold themselves out to handle only §1031 reinvestment plans are qualified. [Rev. Regs. §1.1031(k)-1(k)(2)(i)]

However, financial institutions, title insurance companies or escrow companies who perform routine financial, title insurance, escrow or trust services for the investor are qualified to receive the identification statement. [Rev. Regs. §1.1031(k)-1(k)(2)(ii)]

Thus, the broker handling a §1031 transaction for the client can receive the property identification statement if the broker’s only representation of clients was as a §1031 exchange broker during the two-year period prior to the transaction. [Rev. Regs. §1.1031(k)-1(k)(5), Example 1 (iii)]

Other disqualified persons include:

  • close family members, including brothers and sisters (whole or half blood), spouse, ancestors and lineal descendants; and
  • a corporation or partnership in which more than 50% of outstanding stock, capital interest or profit interest is owned by the investor or the investor’s agent. [Rev. Regs. §1.1031(k)-1(k)(3)]

To avoid the issues of a disqualified person, the investor should deliver the identification form to the §1031 trustee holding the net sales proceeds or the escrow office or title company who handled the closing on the property he sold, not the escrow or title company he intends to use for the property he is identifying (although he could properly do so).

Identifying the properties

The written identification of the selected replacement properties must include the legal description and street address, or assessor’s number, of each property identified. [Rev. Regs. §1.1031(k)-1(c)(3)]

More than one replacement property may be identified. However, the number of potential replacement properties identified places several restrictions on which properties may or must be acquired, such as:

  • with three or fewer properties, without limit on their value, any one or more of which may be purchased;
  • with four or more properties, any one or more may be purchased, provided the combined value of all properties identified is not more than twice (200% of) the price received for the property sold; or
  • identifying four or more properties, the combined value of which exceeds the 200% limitation, requires the purchase of 95% of the total value of all replacement properties identified.

If the investor identifies four or more properties exceeding the values permitted and does not purchase 95% of the total value of all replacement properties identified, then no properties will be treated as having been identified since identification requirements were not met. [IRC §1.1031(k)-1(c)(4)(ii)]

The rules for identification of four or more properties include any replacement properties purchased during the identification period.

For example, an investor acquires a replacement property within the 45-day period which is priced lower than the value of the real estate sold. Thus, it does not fully offset either the equity or debt in the property sold.

To complete a tax-free §1031 transaction, the investor will purchase additional replacement properties.

Since a replacement property was purchased during the identification period, the property is treated as one of the properties identified if he identifies more properties. Thus, the investor can only identify either:

  • two additional replacement properties (for a total of three) of any fair market value (and purchase one or both); or
  • three or more additional properties whose values (including the value of the replacement property already purchased) do not collectively exceed 200% of the price the investor received for the property sold (and purchase one or more of the newly-identified properties). [Rev. Regs. §1.1031(k)-1(c)(4)(iii)]

The investor must carefully plan the number of potential replacement properties he identifies. The investor risks losing the entire tax benefits of a §1031 transaction if more properties are identified than allowed, or if he does not acquire enough of the identified properties as the 95% rule requires. Improper identification alone causes the entire profit from the sale to be reported, even if the investor timely acquired some of the identified property.

Identification in the case of construction

Replacement property which will be improved by construction prior to taking title qualifies as §1031 property.

However, under the property identification rules for four or more properties with a total value less than 200% of the price of the property sold, the value of the real estate and improvements is the property’s estimated value as improved on the date the investor is to acquire its ownership. [Rev. Regs. §1.1031(k)-1(e)(2)(ii)]

Further, the identification adequately describes the property if the statement includes a legal description or parcel number for the underlying real estate and references plans and specifications for the improvements to be constructed. [Rev. Regs. §1.1031(k)-1(e)(2)]

The 15% incidental personal property rule

Consider an investor who is acquiring an apartment building as replacement property in a §1031 reinvestment plan. The building contains furnishings, washing machines and other personal property which will be acquired as part of the price paid to purchase the apartment building.

The value of the personal property does not exceed 15% of the price being paid for the apartment building. Put another way, of the total purchase price paid for the apartment and furnishings, the furnishings do not exceed 13% of the aggregate price paid for the rental operation.

Does the investor have to list the personal property as replacement property on the 45-day §1031 identification form?

No! Personal property used in the operations of the real estate is considered to be included in the legal description of the replacement property on the identification form, unless the market value of the personal property exceeds 15% of the separate value of the apartment building. [Rev. Regs. §1.1031(k)-1(c)(5)(ii), Example 2]

Personal property which is used in the operation and management of the real estate, called incidental property by the IRS, is treated as part of the real estate under the 15% of value rule.

Taxwise, personal property is treated as part of the real estate when:

  • standard real estate transactions typically transfer the personal property with the real estate; and
  • the value of personal property does not exceed 15% of the separate value of the real estate. [Rev. Regs. §1.1031(k)-1(c)(5)(i)]

Thus, the value of the personal property acquired is not reported as cash boot for the property sold or exchanged.

Revoking an identification statement

An investor locates a few suitable replacement properties. He prepares and sends the property identification form listing the properties to the §1031 trustee.

Before the running of the 45-day identification period, the broker locates other potential replacement properties which are more suitable. The investor sends another, entirely new identification form to the §1031 trustee, listing only three of the newly-located properties, no others. The new identification form contains a written statement revoking the prior identification of replacement properties.

Does the investor need to comply with the 200% rule since six properties were identified?

No! The investor properly revoked the first identifications of replacement properties by hand delivering, mailing, or faxing a written revocation listing the newly-identified properties to the same person who received the initial property identification statement. Oral revocations do not, nor does conduct (identifying more properties), revoke the identifications. [Rev. Regs. §1.1031(k)-1(c)(6)]

Further, the identification of replacement property may be revoked and different properties identified at any time before the running of the 45-day identification period. Later attempts are ineffective.

Acquisition period for replacement property

After identifying the replacement property, ownership of the replacement property must be acquired within the 180-day §1031 acquisition period, called the exchange period by the IRS. The period for closing the purchase escrow – and acquiring the replacement property – ends on the earlier of:

  • 180 days after the date of the close of escrow on the sale of the investor’s property;
  • the date of the actual filing of the taxpayer’s return for the year of sale; or
  • the investor’s tax return due date for the year of the sale, including any extensions for filing. [Rev. Regs. §1.1031(k)-1(b)(2)(ii)]

For example, an investor sells real estate as part of a §1031 reinvestment plan. Escrow closes on December 22. The investor’s federal income tax return for the year in which the property sold is due the following April 15.

The investor files his tax return on April 15, instead of filing an extension (and paying any taxes he may owe).

The investor acquires the replacement property after the return is filed, but still within the 180-day period after the closing of the sales escrow on the property he sold. He then amends his return to include the reporting of the §1031 transaction.

The IRS claims the reinvestment does not qualify the profit from the sale for §1031 treatment since the investor failed to acquire the real estate within the acquisition period established by regulations.

The investor claims the acquisition period ended on June 20, not April 15, since the investor was entitled to the automatic four- month extension whether or not he filed a return on April 15.

However, the transaction does not qualify for the §1031 exemption. The investor did not seek an extension of his filing date to take advantage of the entire 180-day acquisition period. The investor closed out his tax year by filing his return and, of course, was unable to transfer the basis in the property sold to replacement property since he had not yet acquired replacement property when he filed his return.

The investor should have extended the due date of his return by filing the automatic four-month extension. Thus, the exchange period would have ended on midnight of June 20 (except in a leap year), 180 days after the transfer of the investor’s property (and before the due date for or the filing of his return). [Christensen v. Commissioner (1996) T.C. Memo 1996-254; Rev. Regs. §1.1031(k)-1(b)(3)]

Substantially the same property

After 45 days and within the 180-day acquisition period for completion of a delayed §1031 reinvestment, the investor must acquire ownership to substantially the same property he previously identified. [Rev. Regs. §1.1031(k)-1(d)(1)(ii)]

For example, an investor identifies an unimproved parcel of real estate as replacement property. Before expiration of the reinvestment period, and before he owns the replacement property, the investor has improvements, in the form of a fence, constructed on the real estate.

Here, the investor is considered to have received substantially the same property, although he had some minor improvements made on the property before acquisition. The fence does not change the basic character of the parcel of real estate he identified. [Rev. Regs. §1.1031(k)-1(d)(2), Example 2]

Now consider an investor who identifies two acres of unimproved real estate with a fair market value of $250,000. The investor ultimately purchases only 1.5 acres of the real estate for $187,500.

The property is considered substantially the same property as identified since the portion of the unimproved property acquired does not differ from the character of the real estate identified – the owner purchased 75% of the property identified at a fair market value of 75% of the fair market value of the unimproved real estate identified. [Rev. Regs. §1.1031(k)-1(d)(2), Example 4]

Now consider an investor who identifies real estate on which improvements are to be constructed before he acquires ownership. However, the construction is only partially complete when the investor acquires the real estate (and the 180 days is about to run).

Here, the real estate with construction incomplete is substantially the same real estate identified. The improvements, to the extent they exist, are the same improvements the investor identified, just not all of them. [Rev. Regs. §1.1031(k)-1(e)(3)]

However, the improvements completed after the investor closes escrow and acquires ownership are not part of the price paid for §1031 purposes. Thus, the construction completed is not part of the debt or equity in the replacement property which may be used to avoid taxes on some of the profit taken on the property sold. [Rev. Regs. §1.1031(k)-1(e)(5)(iii)]

Also, if substantial changes in construction are made which deviate from the nature of the construction specified to produce an entirely different structure than the one identified during the 45-day period, the replacement property improved with improperly identified construction will not be considered §1031 property. [Rev. Regs. §1031(k)-1(e)(3)]