Identification of alternative replacement properties is valid if the taxpayer identifies no more than three alternative replacement properties as part of the same deferred exchange, regardless of the values of the relinquished or replacement properties. Reg §1.1031(k)-1(c)(4)(i)(A), (c)(7), Example 4. The taxpayer need not have entered into a binding contract to purchase any of the identified replacement properties at the time of identification.

The three-property rule limits the identification of alternative replacement properties to three, regardless of the number of relinquished properties transferred as part of the "same" deferred exchange.

The three-property rule limits the identification of alternative replacement properties to three, regardless of the number of relinquished properties transferred as part of the "same" deferred exchange.

EXAMPLE: If a taxpayer transfers five properties in the same exchange, only three replacement properties may be identified under this rule; but if a taxpayer is able to separate the transfer of the relinquished properties so that the transaction is not treated as the same deferred exchange, the taxpayer may identify up to three properties for each relinquished property.

Under the three-property rule, the taxpayer need not state the fair market value of any of the replacement properties or the terms on which the taxpayer would be willing to acquire one or more of them. Further, the taxpayer need not state any order of preference or priority as to which alternative property the taxpayer prefers to acquire. The taxpayer is required, however, to receive the same or substantially the same property as one or more of those that were identified Reg §1 1031(k)-I(d)(1)(ii).

As with relinquished property, what constitutes a single property for purposes of the three-property rule is not entirely clear. For example, it is unclear whether unimproved property subdivided into multiple parcels, or an apartment building or a commercial building, operated as a single rental building, that has been subdivided into multiple condominium parcels, constitutes a single replacement property. One approach is to treat contiguous property owned by a single seller as a single property, and condominium or apartment units operated as a single rental building or project as a single property, but no guidance has been issued addressing this issue.

WARNING: The drastic results of over-identification suggest that extreme caution be used in analyzing whether contiguous property is treated as a single property or multiple properties under the three-property rule.

When the taxpayer identifies more than three alternative replacement properties in connection with the same deferred exchange, the identification is valid as long as the aggregate fair market value of all replacement properties at the end of the identification period does not exceed 200 percent of the aggregate fair market value of all the relinquished properties in the exchange on the date or dates on which the taxpayer transferred the relinquished properties. Reg § 1 1031(k)-1(c)(4)(i)(B).

EXAMPLE: If a taxpayer transfers two parcels of relinquished property with an aggregate fair market value of $100,000, the taxpayer may identify any number of replacement properties as long as the aggregate fair market value of all the identified replacement properties does not exceed $200,000. See Reg §1.1031(k)-t(c)(7), Example 5.

No guidance currently exists on how a taxpayer establishes the identified properties fair market value for purposes of this rule, particularly the value of properties that the taxpayer does not ultimately acquire. It may therefore be advisable, though not mandatory, for a taxpayer to have either a binding contract to purchase any identified property or a completed appraisal for each identified replacement property before the identification period ends in order to be certain that the replacement properties' total fair market value does not exceed 200 percent of the relinquished property's value. This rule focuses on the properties' fair market value (Reg §1,10.31(k)-1(m)); encumbrances and relative equities in the replacement and relinquished properties are disregarded. Although the IRS debated using a rule based on the equity in the identified properties, it concluded that such a rule would be too difficult to apply, especially because taxpayers have so much control over the equity of replacement properties.

Compliance with the 200 percent rule is more complex and uncertain than is compliance with the three-property rule. Taxpayers should state the fair market value of each replacement property in their identification notices and be prepared to support their estimates with contemporaneous third party evidence such as appraisals.

WARNING:If the replacement properties are not subject to binding purchase contracts when the identification period ends, the taxpayer runs the risk that the IRS might not accept an appraiser's valuation. If the IRS claims a higher valuation of an identified property, it may assert that the identification did not meet the 200 percent rule. There is no evidence to date, however, that the IRS is inclined to make such claims, at least when there is no evidence of fraud.

Another difficult issue could arise if an identified replacement property is appraised at a certain value at the end of the identification period, but the taxpayer must later pay a greater purchase price because a binding contract was not in effect at that time. Because the relevant valuation date is the end of the identification period, an accurate appraisal should constitute sufficient proof of compliance with the 200 percent rule. The actual purchase price paid should not be conclusive evidence of fair market value, because a buyer could pay more for a certain property than anyone else would pay, solely for subjective reasons. In an appreciating market, a taxpayer could pay more for replacement property at the end of the exchange period than the fair market value specified for that property at the end of the identification period and still satisfy the 200 percent rule.

A perfectly valid simultaneous exchange could involve a taxpayer transferring a single relinquished property and acquiring more than three replacement properties whose aggregate value exceeds 200 percent of the value of the relinquished property. The drafters of the deferred exchange regulations recognized that some taxpayers might want to complete such exchanges as deferred exchanges and should be allowed to do so. Accordingly, the 95 percent rule was adopted as a safety valve. Identification of alternative replacement properties is valid even if the taxpayer fails to meet either the three-property rule or the 200 percent rule, as long as the taxpayer receives at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period. Reg §1 1031(k)-I(c)(4)(ii)(B).

EXAMPLE: A taxpayer transfers relinquished property with a fair market value of $1 million and identifies four replacement properties with fair market values of $I million, $1 million, $900,000, and $100,000, respectively, for a total of $.3 million. The taxpayer acquires the first three replacement properties with aggregate fair market values of $2,900,000 but does not acquire the fourth replacement property. Because more than three properties were identified, the taxpayer does not satisfy the three-property rule. Because the aggregate fair market value of the four identified replacement properties is 300 percent of the fair market value of the relinquished property, the taxpayer does not satisfy the 200 percent rule. The 95 percent rule is satisfied, however, because the taxpayer received at least 95 percent of the aggregate fair market value of all identified replacement properties before the end of the exchange period ($2,900,000 divided by $3,000,000 = 96.67 percent).

Under the 95 percent rule, the fair market value of each identified replacement property is ascertained as of the earlier of the date on which the property is received by the taxpayer or the last day of the exchange period Reg §1.1031(k)-I(c)(4)(ii)(B). Note the differences in this date and the date relevant for valuation under the 200 percent rule, which is the last day of the identification period.

WARNINGS: The 95 percent rule leaves little room for error and should be used only when acquisition of sufficient property is virtually certain. If a taxpayer fails both the three-property and 200 percent rules, acquisition of properties representing 94 percent of all identified properties will result in a fully taxable exchange.

The Taxpayer must meet the criteria of at least one of these rules for the identification of replacement properties to be valid.

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