Can You 1031 Exchange Into Multiple Properties?
Understand the strategic considerations and regulatory requirements for using a 1031 exchange to acquire multiple properties and diversify your real estate portfolio.
A like-kind exchange, governed by Section 1031 of the Internal Revenue Code, allows a real estate investor to postpone paying capital gains tax on the sale of an investment property by reinvesting the proceeds into a new one. This strategy allows for the growth of a real estate portfolio by keeping capital at work. A frequent question is whether an investor can sell one property and use the funds to purchase several new ones. This is a common strategy, provided specific IRS regulations are followed.
Rules for Identifying Multiple Replacement Properties
When exchanging one property for multiple, an investor must adhere to one of two identification rules. These rules dictate how many potential replacement properties can be designated. Failure to comply with one of these guidelines jeopardizes the tax-deferred status of the transaction.
The most common guideline is the Three-Property Rule. This rule allows an investor to identify up to three potential replacement properties, regardless of their total market value. For instance, if an investor sells a property for $1 million, they could identify three potential replacement properties valued at $500,000, $750,000, and $1 million. The investor can then choose to purchase one, two, or all three of the identified assets.
To identify more than three potential replacement properties, an investor must follow the 200% Rule. This guideline permits identifying any number of properties, provided the total fair market value of all identified properties does not exceed 200% of the sale price of the relinquished property. Using the same $1 million example, an investor could identify four properties whose combined value could not surpass $2 million.
The 95% Rule is an exception that applies if an investor violates both the Three-Property and 200% rules. This happens if they identify four or more properties whose value exceeds the 200% threshold. To salvage the tax deferral, the investor must acquire at least 95% of the total value of all identified properties. This rule is rarely used as a primary strategy due to its stringent requirement.
The Identification and Exchange Timeline
The 1031 exchange process has strict deadlines that begin when the original property sale closes. The first is the 45-day identification period, during which the investor must formally identify the potential replacement properties they intend to acquire.
This 45-day window is part of a larger 180-day exchange period. The investor has 180 calendar days from the closing of the relinquished property to complete the acquisition of all chosen replacement properties. These two periods run concurrently, meaning the 45-day mark is a milestone within the 180-day timeframe.
These deadlines are absolute and are not extended for weekends or holidays. Missing either deadline will disqualify the transaction from 1031 exchange treatment, and the sale proceeds will become fully taxable.
Required Information for Formal Identification
To formally identify potential replacement properties, an investor must provide the information in a written document signed by the taxpayer conducting the exchange. This written notice is a legal requirement and serves as the official record of intent.
The document must contain an unambiguous description of each potential replacement property, sufficient to distinguish it from any other. Acceptable descriptions include the property’s street address and city or a complete legal description.
Once prepared and signed, this written identification notice must be delivered to a non-disqualified party, such as the Qualified Intermediary (QI), before midnight on the 45th day. The QI is a neutral third party who facilitates the transaction.
Completing the Exchange for Multiple Properties
After identifying properties, the investor focuses on acquiring them within the 180-day exchange period. The Qualified Intermediary holds the proceeds from the sale of the relinquished property in a secure account and uses these funds to purchase the replacement properties on the investor’s behalf.
Coordinating the closings for multiple properties requires careful planning to ensure all acquisitions are completed before the 180-day deadline. Each purchase is a separate real estate transaction with its own closing process. The investor directs the QI to wire the necessary funds for each closing.
To achieve full tax deferral, the investor must satisfy two financial requirements. First, the total purchase price of all acquired replacement properties must be equal to or greater than the net selling price of the relinquished property. Second, the investor must acquire debt on the new properties that is equal to or greater than the debt that was paid off on the old property. Any shortfall in value or debt replacement is considered “boot” and is subject to capital gains tax.