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 owner has entered into a purchase agreement to sell like-kind property. The purchase agreement provides for a 90-day escrow period and contains provisions calling for:

  • the buyer to cooperate with the funding of the owner’s §1031 reinvestment plan; and
  • the owner to locate replacement property as a condition for closing escrow.

The owner’s broker is coordinating the sale and purchase of property on behalf of the owner so the owner will maintain a continuing investment in like-kind property. A replacement property is located and the owner enters into a purchase agreement with the sellers, a tenants-in-common investment group. Closing of the purchase escrow on the replacement property is scheduled to occur concurrent with the date set for the close of the owner’s sales escrow.

However, one of the tenants-in-common who co-own the replacement property has died. His interest has not yet been cleared from title into the names of his heirs/beneficiaries or the remaining tenants in common. Until title to the replacement property can be conveyed and a title insurance policy can issued for the conveyance of the entire fee simple, the owner will not waive his contingency in his sales escrow to remove the condition that he first locate a replacement property before closing the sales escrow.

As the deadline for closing the two escrows draws near, it becomes clear that the title to the replacement property cannot be cleared in time for the purchase escrow to close as scheduled. Thus, a concurrent closing of the sales escrow and the purchase escrow will not be possible. Accordingly, the owner considers waiving the purchase-of-other-property contingency and closing escrow on his sale.

The risk taken by the owner by waiving the contingency and closing is that if title to the replacement property cannot be delivered within 180 days of his closing his sales escrow he will lose his §1031 exemption. However, the attorneys involved on behalf of the owner believe the delay in clearing title is merely temporary and no other foreseeable obstacles exist to the issuance of title insurance and transfer of title within the next several weeks.

The broker is now confronted with the owner’s acquisition of the replacement property after he has closed escrow on his sale. Thus, the owner has become involved in a delayed §1031 transaction, called a deferred exchange by the IRS. The owner is selling one property and on a different (and later) date is acquiring ownership of another in unrelated transaction. Thus, the owner is still engaged in two mutually exclusive transactions, only now the closings will not be concurrent.

To qualify the owner’s profit on his sale for the §1031 exemption when the purchase escrow for the acquisition of ownership to the replacement property will not close concurrent with the owner’s sales escrow, the broker advises the owner he needs to consider taking the following steps:

  • prepare closing instructions directing the sales escrow to hand the owner’s net proceeds to a buyer’s trustee, commonly called an accommodator or facilitator;
  • prepare closing instructions directing escrow to credit the owner with Exchange Valuation Credits (EVCs) in lieu of a check from escrow for the net sales proceeds as originally agreed;
  • select an entity or individual the owner knows and trusts to be appointed (by the buyer under a buyer’s trust agreement) as the trustee who will receive and hold in trust the net proceeds from the sale and, on further instructions from the owner, fund the owner’s down payment and closing costs in the purchase escrow for the replacement property;
  • identify within 45 days after closing the sales escrow, two alternative properties for purchase as replacement property should the purchase escrow for the replacement property fail to close for any reason within the 45-day period; and
  • close escrow on the purchase of a replacement property within 180 days after the sales escrow closes.

The owner decides his risks regarding closing the purchase escrow are sufficiently covered to justify his waiving the purchase-of-other-property contingency and closing his sale.

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

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 property sold would not be exempt from taxes under §1031. [Rev Regs. §1.1031(k)-1(a)]

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)]

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 on a §1031 property identification form. [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 owner who is conveying (selling) the replacement property to the investor; or
  • any entity or individual involved in the §1031 transaction, except the investor or those who are disqualified. [Rev Regs. §1.1031(k)-1(c)(2); see Form 360 accompanying this article]

Persons to whom the identification statement may be delivered include the escrow agent or title company who were involved in the sale of the investor’s property, even though the sales escrow has already closed.

Persons to be notified of 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. Also, all listings and sales have been handled on behalf of the investor as §1031 transactions.

Is a real estate broker who is exclusively involved in §1031 transactions, a person who is qualified to receive the identification statement?

Yes! 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 and do only handle §1031 reinvestment plans are qualified. [Rev Regs. §1.1031(k)-1(k)(2)(i)]

Also, 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 only if the broker’s 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 chosen to be identified places different restrictions on which properties may or must be acquired, such as:

  • when identifying three or fewer properties, without limit on their value, any one or more may be purchased;
  • if four or more properties are identified and the combined value of all properties identified is not more than twice (200% of) the price received for the property sold, any one or more may be purchased; or
  • when identifying four or more properties and the combined value of all properties exceeds the 200% limitation, the investor is required to purchase 95% of the total value of all replacement properties identified to qualify for the §1031 profit-tax exemption.

If the investor identifies four or more properties with a combined value exceeding the 200% value ceiling and then does not purchase 95% of the total value of all replacement properties identified, no properties will be treated as having been identified since identification and acquisition requirements were not met. [IRC §1.1031(k)-1(c)(4)(ii)]

The rules limiting the identification of properties include any replacement properties purchased during the identification period.

For example, an investor acquires ownership of a replacement property within the 45-day period which is priced below the price the investor received for the real estate he sold. Thus, the debt and equity in the property acquired do not fully offset the debt and equity in the property sold.

To complete a fully qualified tax-free §1031 transaction, the investor will purchase an additional replacement property with the funds remaining from his sale.

Since a replacement property was already been purchased during the identification period, the property acquired is treated as one of the properties identified if he identifies more properties. Thus, the investor who has acquired one property is limited to either:

  • identifying two additional replacement properties (for a total of three) of any fair market value and purchase one or both; or
  • identifying 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 the §1031 exemption if more properties are identified than allowed, or if he does not acquire enough of the identified properties should he fall under the 95% rule. Improper identification alone will cause the entire profit from the sale to be reported (taxed as recognized gain), even if the investor timely acquired some of the identified property.

Identification in the case of construction

Replacement property controlled by an investor or businessman under a purchase agreement option or escrow instructions which will be improved by construction prior to taking title qualifies as §1031 property.

However, should the property identification include four or more properties intended to comply with a total value of less than 200% of the price of the property sold, the value used for the real estate and improvements is the property’s estimated value as improved on the date the investor is to acquire 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 existing plans and specifications for the improvements to be constructed on the identified parcel. [Rev Regs. §1.1031(k)-1(e)(2)]

Also, if substantial changes in construction are made which deviate from the nature of the construction identified by plans and specification in the 45-day notice and produce an entirely different structure than the one identified (an apartment versus a mini-storage facility), the replacement property acquired as improved with improperly identified construction will not be considered the acquisition of §1031 property. [Rev Regs. §1031(k)-1(e)(3)]

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 real estate. Put another way, of the total purchase price paid for the apartment and furnishings, the furnishings cannot exceed 13% of the aggregate price paid for the rental operation; land, improvements and furnishings.

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, such as the sale of a hotel or motel, 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 preparing a written revocation of the prior identification statement listing the newly-identified properties which was hand delivered, mailed or faxed to the same person who received the initial property identification statement. Oral revocations do not, nor does conduct (merely identifying more properties), revoke the prior 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 escrow closed on the sale of the investor’s property;
  • the date the taxpayer’s return for the year of sale is actually filed; or
  • the due date for filing the investor’s tax return 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 dutifully 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 – prior to filing his tax return on the sale.

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.

Does the transaction qualify for the §1031 exemption?

No! The investor did not elect to extend his filing date to take advantage of the entire 180-day acquisition period available to him. The investor closed out his tax year (and his §1031 reinvestment plan) by filing his return. Of course, he was unable to couple the sale of his property, which was reported on his tax return, with the transfer of its basis to the  replacement property which was not reported, 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, not his return. With an extension, 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 filing his return). [Christensen v. Commissioner TC 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 becomes the owner of the replacement property, the investor has improvements constructed on the real estate in the form of a fence.

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 20 acres of unimproved real estate with a fair market value of $250,000. The investor ultimately purchases only 15 acres of the real estate for $187,500.

The property is considered substantially the same property as he 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 and the improvements which are to be constructed before he acquires ownership. However, the construction has only been partially completed 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 as the property 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 value of the further improvements needed to complete construction after the investor closes escrow and acquires ownership are not part of the price paid (or debt assumed) for §1031 purposes. Thus, the value of the portion of the construction yet-to-be completed is not part of the debt or equity in the replacement property and may not be used to avoid taxes on some of the profit taken on the property sold. [Rev Regs. §1.1031(k)-1(e)(5)(iii)]