What Is the Three-Property Rule for Tax-Deferred Exchanges?

A tax-deferred exchange, governed by Section 1031 of the Internal Revenue Code, allows an investor to postpone paying capital gains tax on the sale of a business or investment property by reinvesting the proceeds into a new, “like-kind” property. This process requires formally identifying potential replacement properties within a specific timeframe. One of the most common methods used to meet this requirement is the three-property rule, which provides a clear path for investors while ensuring compliance with tax regulations.

Defining the Three-Property Rule

The three-property rule is a primary method for identifying replacement properties in a 1031 exchange. An investor can identify up to three potential replacement properties without any regard to their fair market value. To successfully complete the exchange under this rule, the investor must purchase at least one of the properties from their identified list. This gives the investor backup options if the primary target property falls through.

For example, an investor sells a commercial building for $1 million. Using the three-property rule, they could identify three potential replacement properties: a duplex valued at $950,000, a small apartment building for $1.2 million, and a parcel of land for $1.5 million. Even though the combined value exceeds the original sale price, the identification is valid because no more than three properties were listed. To complete the exchange, they would then need to acquire just one of these three.

The IRS defines a single property for identification purposes by its distinct legal description. This means a duplex, a four-plex, or even a larger multi-unit building can count as a single property as long as it is all under one legal description. This allows investors to identify significant assets without violating the three-property limit.

The main advantage of this rule is its simplicity. An investor does not need to perform complex calculations regarding the value of the properties they wish to identify. They can focus on finding the best potential investments to serve as replacements, knowing they have a clear path for meeting the identification requirement.

Alternative Identification Rules

If an investor’s strategy requires identifying more than three properties, they must use one of two alternative rules. The first is the 200% rule, which allows an investor to identify an unlimited number of potential replacement properties. The total fair market value of all identified properties, however, cannot exceed 200% of the value of the property that was sold. This rule is often used by investors looking to diversify their holdings.

To illustrate the 200% rule, consider an investor who sells a property for $750,000. They could identify five potential replacement properties. If the combined fair market value of these five properties is $1.5 million or less (200% of $750,000), the identification is valid. The investor would then need to acquire enough of the identified properties to meet the requirements for full tax deferral.

A second, less common alternative is the 95% rule. This rule acts as a fallback if an investor inadvertently violates both the three-property and 200% rules. To qualify, the investor must acquire replacement properties that amount to at least 95% of the total fair market value of all properties they identified. This is a demanding requirement that means the investor must purchase nearly every property on their list.

For instance, if an investor sells a property for $1 million and identifies properties collectively valued at $2.5 million (violating the 200% rule), they would fall under the 95% rule. To complete the exchange, they would be required to purchase at least $2,375,000 (95% of $2.5 million) worth of the identified properties. Because of this high threshold, the 95% rule is rarely used as a primary strategy.

The Formal Identification Process

Regardless of which identification rule an investor chooses, the process for formally identifying properties has strict procedural requirements. The identification must be made in a written document signed by the taxpayer. This notice must contain an unambiguous description of each potential replacement property, such as a property’s street address or its legal description.

This signed identification notice must be delivered before midnight on the 45th calendar day following the closing of the sale of the relinquished property. This 45-day period is absolute and cannot be extended, even if the final day falls on a weekend or holiday. The notice must be sent to the Qualified Intermediary handling the exchange or another non-disqualified party involved in the transaction. Sending the notice to one’s own attorney or real estate agent is not sufficient.

An investor can change their mind after submitting an initial identification. Identifications can be revoked and a new list submitted, but any changes must be made through a separate signed, written notice within the original 45-day window. Once the 45-day identification period expires, the list is final, and the investor must acquire a property from that list to complete the exchange within the overall 180-day exchange period.