What is the Three Property Rule in a 1031 Exchange?
A 1031 exchange can be your best friend if you are thinking about selling your real estate investment property. This tax deferral strategy allows you to sell one or multiple properties and then buy a like-kind property or properties without the burden of paying a huge amount of taxes on the capital gain at the time of your sale. But naturally, the IRC Section demands that you follow a strict set of rules before you can reap the benefits from a 1031 exchange. One such rule is widely known as the Three Property Rule.
If you are considering a 1031 exchange for the sale of your investment property you may have already started looking for a replacement home that will help you defer your capital gains tax. Because it can be difficult to find the right property to complete your exchange within the 180 day period of eligibility, the rules allow for you to target up to three properties for your reinvestment. What exactly is this Three Property Rule and what do you have to do to follow it? You have come to the right place to find out!
The definition of the Three Property Rule set up by IRC states that an exchanger or taxpayer executing a 1031 exchange will get 45 calendar days from the closing date of the sale of their first relinquished property or properties to formally identify up to three replacement properties.
How many properties among the three do you need to buy?
The laws and regulations of the 1031 exchange clearly state that even though you can identify up to three properties within the 45-day window from the date of the closing of your first sale, you are not at all committed to buying all three of them. You can buy one, two or all three properties among the three identified and the tax deferral will still be effective. You also have the option to revoke a property from your list of identified properties. There is no limit on how many times you can add or remove properties from the list, just as long as the list is finalized within the 45-day timeframe.
You should keep in mind that whether you buy just one or all three among the identified properties, the market value of your replacement property must be equal to or greater than your relinquished property. One other important thing to remember is that you must acquire the identified replacement property or properties within the 180-day exchange period, otherwise, the 1031 exchange will not be effective for deferring your taxes.
Alternatives to the Three Property Rule
You may ask, “what if I want to identify more than three properties? Will the tax deferral strategy still work?” The answer is yes! In that case, the 3 Property Rule no longer apply, and you will slip into the 200% Rule. According to this rule, you can identify more than three replacement properties so long as the aggregate value of your replacement property does not exceed 200% of the aggregate value of the relinquished property.
In simple terms, when you aim to trade up value, the Three Property Rule would be more applicable. But if you are trying to diversify across many properties (more than three), then the 200% rule comes into play. As an investor, you should decide which rule between these two will best suit your goals.
Contact me today for a no obligation consultation on deciding which choice is best for you!