IDENTIFYING REPLACEMENT PROPERTY

The Regulations set forth strict guidelines for the identification of replacement property under §1031.

Form of Identification

Under the Regulations, replacement property is treated as identified for purposes of §1031 only if its designation as replacement property is contained in a written document: (i) signed by the taxpayer; (ii) hand delivered, mailed, faxed, or otherwise sent; (iii) before the end of the identification period; and (iv) to the person obligated to transfer the replacement property or to any person involved in the exchange other than the taxpayer or a disqualified person.

The replacement property must generally be unambiguously described in a written document.  One exception to that basic rule is that if a taxpayer actually receives replacement property within the forty-five day identification period. For example, a real property identification is considered unambiguous if it is listed by legal description, street address, or identifiable name.  However, if a taxpayer desires to identify the Holmes Apartment Building, and the city in which it is located is a large one, there may well be several Holmes Apartments within the city.  Therefore, it is best to always provide as much detail regarding the property as possible, including city, state and zip code for street addresses, and amount of acreage, intersection, city, state, zip code, and identifying parcel numbers for raw land.  Tenant-In-Common interest should be identified consistently with their description in the offering memorandum.

Though the Regulations state that identifications may be hand-delivered, it may be wise of a taxpayer to send in their identification by facsimile and by certified mail in order to have substantiated proof of delivery in a timely manner to protect the exchange.

Rules for the Number of Replacement Properties Which May be Identified

The Regulations place certain restrictions on the number of properties which may be identified during the identification period.  There are three rules for identifying property, of which the taxpayer must meet at least one.  They are:

1.            The “3-Property Rule”: A taxpayer may identify up to three properties without regard to the fair market values of the properties;

2.            The “200% Rule”: A taxpayer may identify any number of properties, as long as their aggregate fair market value as of the end of the identification period does not exceed 200% of the aggregate fair market value of the relinquished property sold; or

1. The “95% Rule”: If a taxpayer fails to meet either of the first two tests but ultimately purchases property constituting at least 95% of the aggregate fair market values of all identified replacement properties before the end of the exchange period, then the identification will have been valid.

If, by the end of the identification period, the taxpayer has identified more properties than permitted by the 3-property rule, whose value is in excess of 200% of the sales price of the relinquished property, then they will be deemed to automatically fall under the 95% rule.  If they then do not purchase at least 95% of all properties identified, they will be judged to have not identified at all, and their exchange will become void, terminating at midnight on the last day of the exchange period, causing a taxable event.

Revocation of Identification

A taxpayer may revoke her identification at any time prior to the end of the identification period.  The revocation will only be valid if it is in writing, signed by the taxpayer, and delivered to the person to whom the identification of replacement property was originally made on or before midnight of the 45th day of the identification period.

Incidental Property

Property is considered incidental if it would be ignored for purposes of a commercial transaction and its aggregate value does not exceed fifteen percent of the aggregate fair market value of the overall transaction.  For example, a spare tire and tool kit would not be separate property from a truck, and coin operated laundry equipment would not be separate from an apartment complex being sold. However, in the sale of a convenience store with gas pumping equipment, furniture and fixtures, the aggregate value of the personal property may well exceed fifteen percent, or be required to be treated separately in a commercial transaction.  In those instances, the personal property is not incidental and must be separately identified.

The de minimus rule for incidental property is limited to determining the qualified status of a property identification.  Even though the washing machines in an apartment complex may not need to be identified separately, they must be accounted for as if a multiple property exchange is being undertaken. The apartment complex provides a simple example of this structure:

In an exchange transaction, Taxpayer A sells an apartment complex including washers and dryers.  Total sales price is $1,000,000 and the value of the machines is $150,000.  The machines have been fully depreciated.  Taxpayer then identifies a replacement apartment complex with a fair market value of $1,000,000 inclusive of washers and dryers with a fair market value of $140,000.  The identification is valid (less than 15% of FMV and not specifically required to be stated separately). However, Taxpayer A has created a taxable gain in the amount of $10,000.

Taxpayer A is treated as undertaking two exchanges – one for real property valued at $850,000 and one for equipment worth $150,000.  He receives sufficient real property as replacement property on the Real Property exchange, but only $140,000 of equipment and $10,000 of non-like kind property (the rest of the real estate) in exchange for his relinquished washers and dryers.

In addition to recognizing gain on the transaction, if the property has been subject to depreciation, the likely tax rate will be the depreciation recapture rate and not the capital gains tax rate.  For real property that rate is twenty five percent (25%), and for personal property it is simply the taxpayer’s ordinary income tax rate.