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A Timeline for
A Delayed Exchange
As delayed exchanges are the most common type of a 1031 exchange, it’s imperative for investors to fully understand the importance of following the timeline prescribed by the IRS in order to secure the tax benefits of successfully completing the exchange. Follow the timelines, and capital gains taxes can be deferred indefinitely, possibly even forever. But a single misstep along these carefully constructed timelines can result in the invalidation of the entire exchange, and a whopper of a capital gains tax bill to accompany it.
Before We Begin: The Selection of a Qualified Intermediary (QI)
All 1031 exchanges are facilitated by a qualified intermediary, whose first critical function is to take possession of the proceeds of the sale of the property in question. If the investor seeking to execute a 1031 exchange takes constructive receipt of these funds, little else matters; there is no possibility to execute a 1031 exchange. Accordingly, the choice of a qualified intermediary, or exchange facilitator, is central to the process, and a good QI will ensure a smooth and seamless process for the investor.
Day 1: The relinquished property is sold
The clock starts ticking on a 1031 exchange as soon as the originally-held property, also known as the relinquished property, is sold, and the proceeds of the sale are placed with a QI.
There are two critical deadlines to adhere to in a 1031 exchange: the 45-day deadline, by which at least one, and as many as three, replacement properties must be identified; and the 180-day deadline, by which the transaction(s) must be closed. The sale of the relinquished property is day one of both of these deadlines.
Day 1-45: The Identification Period
The 45 days following the sale of the relinquished property are known as the identification period. The investor must identify potential replacement properties that will constitute the second part of the 1031 exchange.
There are some rules to keep in mind as the investor identifies the property, or properties, in question. We will limit our discussion to the three most important ones.
The 3 Property Rule
The bulk of 1031 exchanges consist of a one-for-one property swap. The investor is, however, allowed to designate as many as three properties for the exchange. Some investors choose to designate three properties so that they can retain the option of selecting one of the three; others choose to exchange their property for all three designated replacement properties. The general limitation of three properties is known as the three-property rule, and it’s important that all three properties are identified during the 45-day identification period, even if the investor ultimately chooses not to include all three in the exchange.
The 200% Rule
The IRS is agnostic as to whether an investor chooses a single replacement property, or up to three. However, the aggregate value cannot generally exceed 200% of the fair market value of the relinquished property. So an investor selling a $1.5 million investment property, for example, is held to a $3 million limit for the replacement(s). In this example, they can identify three replacement properties worth $1 million each, or a single replacement property worth $3 million, but they would run afoul of Section 1031 of the IRC if they tried to identify a pair of $2 million properties, or a single property worth $5 million. In that case, the exchange would be treated as if the investor had failed to identify any replacement properties at all, having failed to identify any which satisfied the 200% rule.
The 95% Rule
There is an exception to both of these rules, however. Investors are permitted not only to exceed three identified properties but to exceed a total of 200% of the fair market value of the relinquished property, if (and only if!) they can successfully close on 95% of the value of each of the replacement properties in question. We’ll review all three of these critical rules—generally referenced as the three-property rule, the 200% rule, and the 95% rule—in much greater detail later in this guide. We also examine all three rules in great depth in our 1031 Exchange Masterclass.
One last consideration to follow during the Identification Period is the identification process itself. One way to identify a replacement property is to close on the property itself during the identification period; any property actually acquired during this 45-day period is deemed to have satisfied the identification requirement. This method makes up a minority of 1031 exchanges, though. Most investors avail themselves of the additional time by signing an Identification Notice and delivering it to the QI no later than day 45 of the identification period. (The Notice can also be delivered to the seller of the replacement property, the title company, or the escrow agent, as long as it avoids landing in the hands of a disqualified person, such as a family member of the exchanger.)
It’s critical that a properly executed Identification Notice not only be signed by the exchanger, but also provide a clear and unambiguous description of the replacement property or properties in question. Most commonly, that description is a street address or a legal description of the property, though it can also be a clearly distinguishable and commonly known name. (So while “that huge skyscraper in Houston that’s the tallest building in Texas” would be insufficient, identifying it as “600 Travis Street, Houston, TX” or “the JP Morgan Chase Tower” is clear enough.)
Where needed, the Notice should also include the percentage of the property being acquired, as well as a description of any improvements being made on the property.
Days 46 – 180 (or 1-180): The Exchange Period
Once the replacement property has been identified, the transaction is on the clock, with an intractable buzzer sounding at the conclusion of day 180. By the end of the 180th day following the sale of the relinquished property, the transaction must be closed. Failure to close it means the loss of all the tax benefits associated with a 1031 exchange. (Section 1031 of the Code actually states that the deadline is the earlier of 180 days or the Federal tax return due date for the year in which the exchange commenced; however, since the IRS routinely grants extensions to October 15th of any given year upon request, the 180 days remains the de facto deadline.)
“By the end of the 180th day following the sale of the relinquished property, the transaction must be closed. Failure to close it means the loss of all the tax benefits associated with a 1031 exchange.”
Daniel Goodwin
These Are Deadlines, Not Guidelines
The IRS is famously inflexible in general, and nowhere is this lack of wiggle room clearer than the strict deadlines of 45 days for the identification period, and 180 days for the exchange period. It matters not at all if day 45 or day 180 (or both) fall on a Saturday, Sunday, or legal holiday, nor does it matter if compelling personal circumstances, including a death in the family or other calamity, beset you as the deadline approaches. Failure to identify property by the end of day 45, or to receive the replacement property by the end of day 180, invalidates a 1031 exchange.
The only exception to this rule is if the IRS issues a Disaster Relief Notice, usually in response to a Federally declared disaster, an act of terrorism, or military action. In such cases, the IRS may elect to extend deadlines by up to 120 days. Even in such cases, it’s important to note that a declaration of disaster by a President, FEMA, or other Federal agency is not sufficient; the IRS itself must issue a formal Notice on its website.
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