What Is the 95% Rule in Tax-Deferred Exchanges?

The 95% rule plays a specific role within tax-deferred exchanges, primarily impacting how taxpayers identify and acquire replacement properties. This rule helps ensure that when multiple properties are identified, the transaction maintains its character as a genuine exchange rather than a disguised cash sale. Adhering to these rules is essential for investors seeking to defer capital gains taxes on real estate transactions.

Understanding Tax-Deferred Exchanges

A tax-deferred exchange, commonly known as a 1031 exchange, allows an investor to defer capital gains taxes when selling a property and reinvesting the proceeds into a new, “like-kind” property. This deferral is granted under Section 1031 of the U.S. Internal Revenue Code. The underlying principle is that the investor’s economic interest remains continuous, merely shifting from one qualifying property to another.

For a property to qualify, it must be held for productive use in a trade or business or for investment purposes. Personal residences or properties acquired for quick resale do not meet this criterion. The objective is to reinvest all sale proceeds into a replacement property of equal or greater value to fully defer the tax.

Sometimes, an investor receives non-like-kind property or cash in an exchange, which is termed “boot.” Boot can arise from various scenarios, such as receiving cash directly, being relieved of more debt on the relinquished property than assumed on the replacement property, or receiving non-qualified assets. While receiving boot does not disqualify the entire exchange, the amount of boot received becomes immediately taxable.

Defining the 95% Rule

The 95% rule is one of three identification rules that taxpayers can use when selecting replacement properties in a 1031 exchange. This rule becomes relevant when a taxpayer wishes to identify more properties than permitted under the other identification methods. Specifically, it allows a taxpayer to identify any number of potential replacement properties, regardless of their combined fair market value.

For the exchange to remain valid under the 95% rule, the taxpayer must acquire replacement properties with a fair market value of at least 95% of the aggregate fair market value of all properties initially identified. This means that if a taxpayer identifies properties totaling $1,000,000, they must acquire at least $950,000 worth of those identified properties.

This rule applies when the “200% rule” is exceeded. The 200% rule allows a taxpayer to identify any number of replacement properties, provided their total fair market value does not exceed 200% of the relinquished property’s value. The most straightforward identification method, the “three-property rule,” permits identifying up to three properties of any value. The 95% rule offers flexibility beyond these limits.

Meeting the 95% Rule Requirements

Ensuring compliance with the 95% rule requires taxpayers to calculate the aggregate fair market value of all identified properties. Within the 180-day exchange period, they must then acquire properties whose total fair market value is at least 95% of that identified aggregate.

If a taxpayer identifies properties with a combined value exceeding 200% of the relinquished property’s value, and then fails to acquire at least 95% of the total identified value, the exchange may face adverse tax consequences. In such a scenario, the Internal Revenue Service may deem that no valid replacement property was identified. This can lead to the immediate taxation of the entire realized gain from the sale of the relinquished property, eliminating the tax deferral benefit.

The calculation involves comparing the fair market value of the properties actually acquired against the total fair market value of all properties initially identified. For example, if $5,000,000 worth of properties were identified, the taxpayer must acquire at least $4,750,000 (95% of $5,000,000) in replacement properties.