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What are the specific rules for identifying replacement property? There are two rules for identifying the replacement property and one exception to the rules:
The three property rule
The 200% rule
The 95% exception
The Three Property Rule
This is the rule used most often in property exchanges. The exchanger is allowed to identify as many as three properties for potential exchange. There is no limit on the fair market value of these properties, under this rule. The exchanger does not have to actually acquire all the identified properties. This allows the identification of back-up properties in the event there is a problem acquiring one or more of the (up to) three identified properties. In any event the fair market value of the replacement property(s) must be at least equal to the actual sales price of the relinquished property(s) or there may be taxes due on part of the sale proceeds.
The 200% Rule
If more than three properties are to be identified, then the 200% of fair market value rule is used. There is no limit to the number of replacement properties that can be identified, but their combined fair market value cannot exceed 200% of the fair market value of the relinquished property(s) inclusive of both debt and equity.
Example
If the fair market value of the relinquished properties is $300,000, the exchanger can identify as many potential replacement properties as he or she wishes, as long as the total fair market value of the properties does not exceed $600,000 (200%) of the relinquished properties' fair market value.
The 95% Exception
If the exchanger identified more than three properties and the fair market value of the identified properties exceeds 200% of the sale price of the relinquished property, the identification may still qualify under the 95% rule. The exchanger must actually acquire identified properties whose value is at least 95% of the total fair market value of the identified properties.
Example
If the exchanger identifies 20 properties, each with a fair market value of $50,000, and is relinquishing a property that sold for $300,000, neither the 200% rule nor the three-property rule applies. As long as the exchanger buys at least 95% of the identified properties in terms of fair market value, the 95% rule applies. In this case, the exchanger would need to buy 19 of the 20 properties.
*Note: Failing to satisfy the identification rules may invalidate the entire exchange and could result in tax being due on the entire amount of gain from the sale of the relinquished property.
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