Click Here. to receive free copies of our newspaper articles.|
Investors can significantly lower the risk of a failed 1031 exchange with proper planning
and the right resources. Investors need to identify risk tolerance, whether they are
looking for appreciation, income or a combination of the two, they need to decide the
level of involvement they want with their investments (do they want an added value
property that will take time and energy or one that produces a monthly check with little or
no involvement) is key to a successful exchange.
Any investment has risk, the questions is how much and how to most effectively manage
that risk. One of the best strategies for managing risk is to diversify. This means
spreading the investments out in different locations, different asset classes and different
There are three rules for identifying replacement properties when doing a 1031 exchange
that need to be considered in the investor's strategy. Which rule the investor chooses to
use will be driven by the investment strategy and replacement properties available at the
time of the exchange.
The three rules are as follows:
1. The 3 Property Rule: Over 90% of the exchanges TM 1031 Exchange is
involved with each year apply this rule because of its simplicity and flexibility.
The disadvantage is that the investor must limit the selection of properties to a
maximum of three. The advantage is that the properties can be of any value and
the investor need not close on all them to maintain the eligibility for the
exchange. When identifying the three properties the investor need only clearly
identify the properties with their name, address and preferably the assessorís
parcel number (APN).
2. The 200% Rule: The investor can identify any number of properties for which
the total fair market value (cash and debt) does not exceed more than 200% of the
relinquished property. When IDing these properties the name, address, total value
(cash and debt) and preferably the APN are used. This rule is far less frequently
used because it limits the total value of the replacement properties and many
investors would like to increase the amount of debt to increase available
depreciation. It should also be noted that this rule does not allow the investor to
materially change the amount of their investment in any one property once
3. The 95% Rule: This rule is seldom used because the investor must close on 95%
of the total value of all identified properties or the entire exchange will be
disqualified. Most investors simply don't want to take the risk that one of their
named properties could fail to close and disqualify the entire exchange.
Using this rule the investor can name any number of properties of any value.
When identifying properties the value (cash and debt), name, address and
preferably the APN, needs to be submitted to the qualified intermediary.
In summary the first step in the planning process is to determine the investment
objectives and that those objectives are realistic in the context of available properties and
the desired risk tolerance. During this process, the above rules should be kept in mind to
make sure that the strategy decided on can be achieved in the framework of the rules
governing 1031 exchanges.
To avoid problems and the possibility of having a failed exchange investors are
encouraged to start planning prior to the sale of their relinquished properties.
While it is better to pay the taxes than to make a bad investment, with proper planning
and resources there is no reason that the investor can't successfully complete their
exchange and realize the benefits of diversification (reduced risk), improved cash flow,
and eliminate management headaches.
Investors are encouraged to consult their tax advisor and/or legal counsel when
contemplating doing a 1031 exchange.
Top of Page