The Three Identification Rules, Properly Explained

Almost everyone selling investment property has heard that a 1031 exchange lets you identify three properties. Far fewer know that is only one of three available rules, and that the other two allow you to name considerably more.

That matters, because the number of properties you may name is the number of chances you have if something goes wrong. Get this part right and a failed deal on day 60 is an inconvenience. Get it wrong and it is a tax bill.

This article explains all three rules, which one to rely on, and the trap in the third. It is educational only and is not tax or legal advice. Confirm your identification with your Qualified Intermediary before day 45.

What identification actually is

Before the rules, the mechanics, because people get this wrong too.

Identification is a written document, signed by you, and delivered to your Qualified Intermediary by midnight on day 45. Not a conversation with your agent. Not a property you have in mind. Not an offer you have made. A signed document, delivered.

Each property must be described unambiguously, which in practice means a street address or a legal description. A vague description is treated as no identification at all.

You may revoke and replace your identification as often as you like before the deadline, provided each revocation is also in writing and delivered. After midnight on day 45 the list is fixed permanently.

Rule one: the three property rule

You may identify up to three properties of any value.

There is no ceiling. You can sell a 500,000 dollar duplex and identify three properties worth ten million each. Value is simply not part of this test.

This is the rule almost everyone uses, because it is simple and it needs no arithmetic. If you are naming three or fewer properties, you are relying on this rule and there is nothing further to think about.

Rule two: the 200 percent rule

You may identify any number of properties, provided their combined fair market value does not exceed 200 percent of what you sold.

Sell for one million and you may identify as many properties as you like so long as they add up to no more than two million. That could be four properties at 500,000, or eight at 250,000, or twenty at 100,000.

This rule exists for people who need more than three names, and it is genuinely useful in one specific situation: spreading an exchange across several smaller positions. If you are considering fractional interests, where a typical minimum is far below your total proceeds, three slots is restrictive and the 200 percent rule is what makes a diversified identification possible.

The arithmetic uses fair market value of the properties you identify, not the amount you intend to invest in each. Identify a two million dollar building intending to buy a ten percent share, and the full two million counts against your limit.

Rule three: the 95 percent rule, and why it is a trap

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

Read that again, because it is not the escape hatch it appears to be.

If you identify ten properties worth a million each, you must acquire at least 9.5 million of that ten million. In practice that means buying nine or ten of them. Identifying twenty properties and buying one is precisely what this rule does not allow.

The 95 percent rule is not a safety net for over-identifying. It is a narrow provision for someone genuinely intending to acquire almost everything on their list, which is rare. Anyone relying on it as a fallback has misunderstood it.

You do not choose in advance

Here is the part that surprises people: you do not declare which rule you are using. There is no box to tick.

Your identification is simply tested against all three at the end. If it satisfies any one of them, it is valid. If it satisfies none, you are treated as having identified nothing at all, and the exchange fails entirely.

So an identification of four properties is not automatically invalid. It fails the three property rule, but if those four add up to less than 200 percent of your sale price it passes the second rule and is perfectly good. It is the combination that matters, not the count on its own.

What this means in practice

If you are naming three or fewer, stop worrying. You are inside rule one regardless of value. This covers most exchanges.

If you want more than three, do the arithmetic. Add up the fair market values of everything you intend to name. If the total is under twice your sale price, you are fine. If it is over, you must either cut the list back or genuinely intend to buy 95 percent of it, and the second of those is almost never the answer.

Use the slots you have. This is the practical point. Roughly one commercial transaction in five does not complete for reasons entirely outside the buyer's control, and after day 45 you cannot add a name. Identifying one property is a plan with no margin for error in a process that regularly produces errors.

Naming three costs nothing. There is no fee, no obligation and no commitment to buy any of them. You are preserving an option, and you either use it or you do not.

A sensible identification

For most people the useful shape is:

• ›Your first choice, the property you actually want.
• ›A genuine second choice, something you would be content to own if the first falls through.
• ›Something that can definitely close, which in practice means an option that is already acquired and ready to subscribe rather than a transaction that could collapse.

That third slot is the one that matters on day 60, and it is the one most people leave empty.

The short version

Three rules, not one. Up to three properties of any value, or any number totalling under 200 percent of your sale, or any number at all if you buy 95 percent of it. You do not choose in advance and your list is tested against all three.

The rules are more generous than almost anyone realises. Very few people use that room, and the ones who do not are the ones with nowhere to go when a deal fails.

Want to know what could realistically fill your third slot? Download the current property list and a licensed specialist will show you what is open now and how quickly each option can complete. Free, and no obligation.

About this article. 1031Property is an independent information and referral service. We are not a broker dealer, a Qualified Intermediary, a tax adviser or a law firm, and we do not sell securities or property. Nothing here is tax, legal or investment advice. Delaware Statutory Trust interests are securities offered to accredited investors only through a licensed broker dealer and definitive offering documents, and investing involves risk including the loss of principal. Confirm your identification with your own Qualified Intermediary and CPA before day 45.