The 200 Percent and 95 Percent Rules, Worked Through With Numbers

Almost every discussion of 1031 identification focuses on the three property rule, because most exchanges use it. The other two rules, the 200 percent rule and the 95 percent rule, get a sentence each.

That is a shame, because they solve real problems. They also carry specific traps. The only way to understand them is with numbers.

Why would you need anything beyond three properties?

Three properties is usually enough for someone buying one or two buildings. It is not always enough for investors who:

• ›Want to diversify into several smaller properties
• ›Are buying several fractional interests, such as Delaware Statutory Trust units
• ›Want several backup options because the market is competitive
• ›Are exchanging a large property into a portfolio

In those cases, the other identification rules allow more than three properties.

How does the 200 percent rule work?

You may identify any number of properties, as long as their total fair market value does not exceed 200 percent of the value of the property you sold.

Example. You sell a property for 2 million dollars. Under the 200 percent rule, the combined value of everything you identify must not exceed 4 million dollars.

You could identify:

• ›A 1.2 million dollar net lease building
• ›A 900,000 dollar apartment building
• ›A 700,000 dollar DST interest
• ›A 600,000 dollar DST interest
• ›A 500,000 dollar industrial building

That is five properties totalling 3.9 million dollars, within the 4 million dollar limit. You can then buy any combination that adds up to your required reinvestment.

The value is fair market value on the date the property is received or at the end of the identification period, depending on the circumstance, not simply the asking price. If the market moves or an appraisal differs, a tightly packed list can breach the limit. Leave a margin.

What happens if you exceed 200 percent?

If you identify more than three properties and their total value exceeds 200 percent, the identification may be treated as if you had identified nothing, unless you meet the 95 percent rule instead. An exchange with no valid identification fails entirely.

That is why investors using the 200 percent rule should calculate the totals conservatively.

How does the 95 percent rule work?

You may identify any number of properties of any total value, as long as you actually acquire at least 95 percent of the aggregate value of everything you identified.

Example. You identify six properties with a total value of 5 million dollars. To satisfy the rule, you must acquire at least 4.75 million dollars of them.

If you buy five properties worth 4.5 million dollars and one purchase falls through, you acquired only 90 percent. The identification fails, and the exchange fails with it.

Why is the 95 percent rule so dangerous?

Because it depends on almost everything going right. It is typically used only when an investor is highly confident of closing on nearly every identified property, such as a planned portfolio purchase with signed contracts.

Using it as a way to list many backups defeats its purpose. Backups you do not buy reduce the percentage acquired.

Can you revoke identifications?

Yes, before the end of the 45 day identification period. Revocations must be made in writing and delivered in the same way as identification. After day 45, the list is fixed.

Properties you actually acquire before the end of the 45 day period are also treated as identified, which can matter when calculating totals.

How do these rules apply to DST interests?

Investors often identify several DST interests to diversify or to create backups. Under the three property rule, each DST offering usually counts as one property, so three offerings uses all three slots.

The 200 percent rule allows more offerings, provided the total value stays within the limit. Because DST interests can be purchased in precise amounts, investors can identify amounts that fit neatly within 200 percent.

What about incidental property?

Some replacement properties come with minor personal property included, such as furniture or equipment. If that personal property is incidental, typically not exceeding 15 percent of the value of the larger real property, it generally does not need to be identified separately and does not count as a separate property for the three property rule.

That does not make the personal property itself like kind. Since 2018 only real property qualifies for deferral, so the value of included personal property may still be taxable. The incidental property rule simply keeps it from complicating the identification count.

Which rule should you use?

• ›Three property rule for most exchanges, and whenever you want simple backups
• ›200 percent rule for diversified portfolios with several properties, calculated with a margin
• ›95 percent rule only when you are nearly certain of closing on every identified property

What to do first

Before identifying more than three properties, calculate the total identified value against 200 percent of your sale price. If the total exceeds that limit, ask whether you truly intend to buy 95 percent of it. If not, reduce the list. Confirm the calculation with your Qualified Intermediary before day 45.

Nothing here is tax, legal or investment advice. Identification rules are technical and depend on your facts. Confirm your plan with your CPA and Qualified Intermediary before acting.