What Is the 90% Rule for a 1031 Exchange?
Understand the strategic options for identifying replacement properties in a 1031 exchange and the strict acquisition requirements tied to each choice.
A 1031 exchange allows an investor to defer paying capital gains taxes on the sale of a business or investment property by reinvesting the proceeds into a new, similar property. This tax deferral is governed by Section 1031 of the Internal Revenue Code. To successfully execute an exchange, the taxpayer must adhere to IRS regulations, including rules for formally identifying potential replacement properties within a specific timeframe. Failure to follow these guidelines can result in the entire gain becoming immediately taxable.
The Three Identification Rules
To proceed with a 1031 exchange, an investor must satisfy one of three distinct rules for identifying replacement properties. An investor only needs to meet the requirements of one of these options for the exchange to remain valid.
The first option is the 3-Property Rule. Under this guideline, an investor can identify up to three potential replacement properties, regardless of their fair market value. Acquiring just one of the three identified properties is sufficient to meet the rule’s requirements.
A second option is the 200% Rule, which applies when an investor identifies more than three properties. This rule permits identifying any number of properties, on the condition that their total fair market value does not exceed 200% of the value of the property being sold. For example, if the relinquished property was sold for $1 million, the investor could identify properties as long as their combined value is no more than $2 million.
The final option is the 95% Rule, which serves as an exception for investors who cannot meet the first two rules. This situation arises when an investor identifies more than three properties whose aggregate value also exceeds the 200% limit. The 95% Rule allows for this but imposes a much stricter acquisition requirement.
Applying the 95% Rule
The 95% Rule states that if an investor identifies more than three properties with a combined value exceeding 200% of the relinquished property’s sale price, they must acquire properties from that list worth at least 95% of the total value of all properties identified. This rule is an “all or nothing” proposition, where a small shortfall can have major tax consequences.
To illustrate, an investor sells a property for $1 million and identifies five replacement properties with a total fair market value of $3 million. Since this is more than three properties and exceeds the 200% limit ($2 million), they are bound by the 95% Rule. To complete the exchange, they must purchase properties from their identified list with a combined value of at least $2.85 million (95% of the $3 million total).
The consequences of failing to meet this threshold are severe. If the investor in the example acquires properties worth only $2.84 million, the entire 1031 exchange is disqualified. This means the capital gains from the original $1 million sale become fully taxable.
Because of this high-stakes requirement, the 95% Rule is often a last resort. It is used in scenarios where an investor is acquiring a large portfolio of properties and is confident that nearly all the deals will close, as an unexpected issue with a single property can jeopardize the entire transaction.
Formal Identification Requirements
Regardless of which of the three rules an investor uses, the IRS mandates a formal process for identifying the chosen replacement properties. The first deadline is the 45-day identification period, which begins the day after the relinquished property sale closes. The identification must be finalized by midnight on the 45th day, and this deadline is not extended for weekends or holidays, except in cases of federally declared disasters.
The identification itself must be made in a written document that is signed by the taxpayer. This written notice must contain an “unambiguous description” of each potential replacement property, such as a legal description, a street address, or a distinguishable name. If identifying a condominium or a portion of a larger property, the specific unit number or percentage of interest being acquired must also be clearly stated.
This signed, written identification notice must be delivered to a party involved in the transaction who is not the taxpayer or a disqualified person like their agent. This notice is sent to the Qualified Intermediary who is facilitating the exchange or delivered to the seller of the replacement property.