A 1031 exchange is a real estate investor’s best friend. When you sell an investment property for a big profit, your wallet can take a big hit during tax time. But a 1031 exchange lets you delay paying any taxes on your investment properties for as long as you like.
This process is more complex than simply selling one property and buying another. You need to meet specific requirements to complete a 1031 exchange.
One of these is the requirement that you identify replacement properties within 45 days from the date you sell the original property. This is easier said than done. And there are other things you need to do, too. Here’s a quick guide that can help you get started on the right foot.
The 45-day rule
When you close on the sale of your original investment property, the 45-day identification window begins. You have 45 calendar days, not business days, to identify potential properties you could buy to complete the 1031 exchange.
You have two options here. You can identify:
- up to three identified replacement properties or
- as many replacement properties as you want if the total market value doesn’t exceed 200% of the value of the property or properties you sold to initiate the exchange.
You can change your mind if you’re still within the 45-day window (for example, if one of your identified properties sells to someone else). But be sure to revoke your original identification letter or both will count and could violate these rules.
You don’t have to buy all of your identified properties. If you identify three potential replacement properties, you can acquire one, two, or all three of them.
Say you sell a property for $1 million and buy one of your identified properties for more than $1 million. That could satisfy the requirements for a completed 1031 exchange by itself.
In other words, while you could buy all the properties you identify, you can look at the three-property rule as a first choice and a couple backups.
The same principle applies to the 200% rule. If you sell an investment property for $1 million and identify five properties with a combined value of $2 million, you don’t have to buy all five. You can purchase any combination of the identified properties. As long as the purchase price is equal to or greater than the sale price of the original property, you can still defer taxes.
You can even acquire just one of your identified properties for less than the original property’s sale price. This is a partial 1031 exchange and it defers some of your taxes.
You must identify the replacement property or properties by the end of the 45-day window. Make the identification in signed written document that's delivered to your 1031 exchange facilitator. This is generally your qualified intermediary.
In this document, clearly describe the replacement property using information like its street address or legal description. "Duplex on Elm Street” isn't an acceptable identification of a potential replacement property.
Here's something else to know: If you close on a property within the 45-day window, the formal identification requirement doesn't apply to you. The property you acquire has been “identified” automatically.
How to find replacement properties for your 1031 exchange
Here’s the good news. While the 45-day identification window goes by quickly, there are tons of possibilities when it comes to identifying potential replacement properties.