Specific rules and regulations must be followed for a successful 1031 Exchange, such as identifying Replacement Property within forty-five days of the closing of Relinquished Property. For most exchanges, the identification rules are not difficult to follow. But what happens if the property or properties the taxpayer plans on identifying do not easily fit into the rules? Let’s look at a few different scenarios.
Scenario Number One: The Three Property rule tends to be the most widely used for identification. Most taxpayers attempt to identify three properties or less to stay within the Three Property rule. But what if a taxpayer desires to identify a building with an adjoining small warehouse and two parking lots that are located on the sides of the buildings? Is the taxpayer identifying one or four properties?
What constitutes one property for identification purposes?
There is no guidance provided in the 1031 regulations or rulings; although Revenue Procedure 2002-22 provides that the IRS will generally treat contiguous parcels of real estate as comprising a single business unit or “property”. However, it is very important to note that this Revenue Procedure was issued in the context of co-tenancies and does not directly apply to the identification rules.
Notwithstanding, many tax advisors consider three factors to determine what makes multiple lots one property for identification purposes. These are:
- the properties are contiguous;
- the properties have a common ownership and are being sold under one contract; and
- the properties are economically connected (have a unity of use).
Examples of being economically connected might be an office building and an adjacent parcel that serves as a parking lot for the office building or a residential rental and a vacant lot next door which serves as an extra side yard. However two single family rentals located next to each other would not have a unity of use because they are separate economic units.
Scenario Number Two: A taxpayer identifies 500 acres of farmland but later determines that he really needs only 420 acres. Is the identification still valid?
Can I buy less property than I identified?
Yes, with a limitation. There is an example in the regulations where a taxpayer identified a two acre parcel of land but only bought one and a half acres or 75% of the property identified. The regulations stated that the taxpayer acquired substantially what was identified.[1] However, the IRS does not consider it a plus or minus rule. Stated differently, you cannot acquire more property than what was identified. The reasoning is, that the additional portion was never identified. Accordingly, it is not like kind and cannot be acquired with 1031 Exchange funds.
Where in the regulations does it say I cannot identify 100% of a parcel but purchase only 60% of what I identified in my 1031 Exchange?
It does not. However, regulation 1.1031(k)-1(d)(ii) provides that the identification requirements are satisfied if “the replacement Property received is substantially the same property as identified”. Example 4 (referenced above) states that 75% is substantially the same. But what about 70% or 60%. This is a question that must be answered by an exchanger’s tax advisor.
Identifying new property to complete a 1031 Exchange within forty-five days of the closing of the Relinquished Property is often a daunting task and the rules in the Tax Code must be followed in order to successfully defer the taxes that would normally be due. When situations such as the above scenarios arise, it is important that taxpayers seek the counsel of their tax advisors to ensure that they are properly identifying the properties on their lists.
[1] Regulation 1.1031(k)-1(d)(2)
READ MORE
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Opportunities of the 1031 Exchange
2 Is Better Than 1: A 1031 Win with Dual Use Property
IPX1031 Knowledge Center
