S.E.C. Real Estate Observer

Identification of Your Replacement Property

As we all know, there are very specific requirements for identifying potential replacement properties in a Delayed 1031 Exchange. The requirements seem pretty clear at first glance, but there can be all sorts of pitfalls when trying to put them into practice.

First, let’s revisit the identification process so that we are all on the same page. The replacement properties that you are considering for your Delayed 1031 Exchange must be identified to your Qualified Intermediary (Exeter 1031 Exchange Services, LLC) no later than midnight of the 45th calendar day following the close of your relinquished property sale transaction.

So, for example, if your relinquished property sale closed on October 31st, the first day of your 45 calendar day identification period would be November 1st and the 45th calendar day deadline would be December 15th. Our article entitled 1031 Exchange Deadlines and Due Dates goes into a lot more detail if you are interested.

The number of properties that you can identify is limited by three identification rules. You must comply with one – and only one – of these identification rules in order to have a valid replacement property identification. The three rules are: (1) Three Property Rule; (2) 200% of Fair Market Value Rule; or (3) 95% Exception Rule. These rules are not important for purposes of this discussion, so I will not delve into them at this time. We go into much greater detail here if you would like to learn more: Identification Requirements for Like-Kind Replacement Properties.

The relevant points for our discussion today are those requirements contained within the Treasury Regulations, including: (1) your replacement property identification must be unambiguous, and (2) you must acquire property that is substantially the same as what you identified.

Identification Pitfalls and Potholes

It is along these lines where life has a very bad habit of getting significantly more complicated when it does not need to, especially when investing in real estate. You will often be confronted with all sorts of ‘what if’s’ and ‘gray areas’ when you’re trying to identify and ultimately acquire replacement properties in your Delayed 1031 Exchange transaction.

The majority of these identification issues can easily be solved, worked around and/or fixed with proper planning. Unfortunately, many investors do not take these issues seriously and often ignore the issues entirely. That is until their Delayed 1031 Exchange is disqualified under a Federal or state audit.
Consider the following examples of potential identification challenges:

Acquisition of a Fractional Interest

The most common identification pitfall stems from investors who intend to acquire a fractional ownership interest or co-ownership interest in real estate together with other co-investors. When it comes time to submit their replacement property identification, the investors routinely identify the replacement property by its street address such as 123 Main Street, Anytown, USA. However, by identifying property merely by using the street address the investor is essentially implying that he or she intends to identify and acquire 100% of the property as opposed to a fractional interest of the real property.

The issues involved here are as follows:

(1) Has the investor unambiguously identified the replacement property?
(2) Has the investor ultimately acquired property that is substantially the same as what he or she identified?

Personally, I can argue this issue both ways. However, the California Franchise Tax Board recently disallowed an investor’s Delayed 1031 Exchange because the investor identified 100% of a property using the street address, but only acquired a 10% fractional interest in the property.

The FTB argued that the identification was ambiguous and that the investor did not acquire substantially the same property as what had been identified. This is clearly just one state’s opinion, but shows the care that should be taken when identifying replacement properties.

Acquisition of Fractional Interest in Syndicated TICs

Syndicated TICs (tenant-in-common properties) are not as popular as they once were, but are still somewhat in play today. Syndicated TICs pose some additional identification challenges that are similar to the problem described above under Acquisition of a Fractional Interest, but have a slightly different twist.
Investors are still buying a fractional ownership interest in a Syndicated TIC and therefore have the same identification issue described above. However, the fractional interest actually acquired by the TIC investor can often be adjusted at the last minute at the closing by the TIC sponsor in order to make room for all investors. This means that an investor could specifically identify a 3% interest and end up with a 2.75% or 3.25% interest in the property.

The same issues are involved here:

(1) Has the investor unambiguously identified the replacement property?
(2) Has the investor ultimately acquired property that is substantially the same as what he or she identified?

I think the answer to the first question is yes, their replacement property identification is unambiguous. However, the problem is that he or she did not receive the exact same percentage as they identified, which raises the second question. One can argue that it is outside of the investor’s control, but ultimately it is what it is.

One can also argue that the percentage received is close to what they identified and therefore is substantially the same as what had been identified. There is an actual example in the Treasury Regulations where the investor ultimately acquired 75% of what they had identified plus other contiguous property, so it would seem that a slight variation in the actual fractional interest acquired might be permissible for Federal tax purposes. However, this could very likely be an issue that some state audit authorities would disagree with.

Multiple Delayed Exchanges Buying Into One Replacement Property

Structuring multiple Delayed 1031 Exchanges with the intent to pool the transactions by acquiring one (1) replacement property is not necessarily problematic, but it does require careful review of the individual identifications.

Generally, investors sell one (1) relinquished property and then acquire one or more replacement properties. These transactions are classic Delayed 1031 Exchange structures and only require a single identification with multiple replacement properties listed on the identification.

However, for strategic planning and/or practical purposes, investors may choose to structure individual Delayed 1031 Exchanges for each of the individual relinquished properties, with the intent to acquire only one (1) replacement property. The investor must be careful when completing the individual identifications for each Delayed 1031 Exchange to identify only a fractional interest in the one (1) replacement property for each of the individual Delayed 1031 Exchanges.

Identifying only the property’s street address such as 123 Main Street, Anytown, USA in each of the individual Delayed 1031 Exchange files would result in identifying more than 100% of the same replacement property between all of the Delayed 1031 Exchanges. Instead, the investor needs to view each Delayed 1031 Exchange as a completely separate transaction with completely different replacement property identifications that can each stand on its own.

Acquisition of Replacement Property Prior to 45th Day

Investors often acquire one or more replacement properties before the end of their 45 day identification deadline (i.e. inside their 45 day identification period). Replacement properties acquired during the 45 day ID period are considered to be properly identified for 1031 Exchange purposes because they were actually acquired through the Qualified Intermediary during the 45 day identification period.

This also means that the properties actually acquired during the 45 day ID period are counted as part of, or toward, the investor’s total properties identified as if the investor had included the property on the written identification made to the Qualified Intermediary. Investors should exercise caution when completing their identification form to ensure they include all properties whether or not they have already been acquired.

Identification and Acquisition of Property Held in a Single Member LLC

Properties are often owned and held in single member limited liability companies. And, for many strategic or practical reasons, investors often make offers to acquire property via a transfer of 100% of the membership interest in the single member limited liability company.

Single member limited liability companies are considered to be pass-thru entities and disregarded entities for Federal income tax purposes. This means that any and all tax consequences pass-thru to the underlying member’s income tax return, and that the legal entity does not exist for income tax purposes.

Generally, this makes complete the 1031 Exchange relatively easy. You can identify the replacement property and then choose to acquire either the property to 100% of the single member limited liability company. However, not all states follow the Federal code in this regard, so care must be exercised when identifying and acquiring potential replacement property as part any 1031 Exchange transaction.

For example, the State of New Hampshire’s Department of Revenue recently issued a ruling that is contrary to the Federal position. The investor in question sold relinquished property, which they owned through a single member LLC, and identified and acquired replacement property through the acquisition and transfer of 100% of the membership interest in another single member LLC, which owned the replacement property. The State of New Hampshire’s Department of Revenue took the position that single member LLCs are not disregarded entities and that the entities in this case were not considered to be the same taxpayer. They therefore disallowed the 1031 Exchange.

These issues can be easily avoided with proper planning and guidance. It is important to remember that state law does not necessarily follow Federal law, especially in terms of selling, identifying and acquiring relinquished and replacement properties that must be of like-kind to each other.

Combined Reverse/Forward or Forward/Reverse Exchange

The identification process gets substantially more complicated when an investor needs to combine a Reverse 1031 Exchange and a Forward 1031 Exchange. There are identification requirements for each separate 1031 Exchange, but they may need to be integrated depending on the over all transaction structure.

Issues Easily Address; Just Require Proper Planning

While the identification issues discussed seem to be overwhelming, they are actually easily addressed with the proper planning and guidance. And, there are certainly other issues that can and do arise when trying to complete your identification of replacement property. Exeter 1031 Exchange Services, LLC is always available to assist you with your identification strategy and process. Call us at (866) 393-8370.

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