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What is Substantially the same in a 1031 Exchange and what is the 75 Rule?

By Four Springs Capital Markets

When doing a 1031 tax deferred exchange, the IRS requires that a taxpayer acquire replacement property that is “substantially similar” to the replacement property that they had “identified” during their 45 day ID period. The replacement property cannot be different in nature or character from what they had described on their identification document.

Typically speaking, taxpayers will run into an issue with their replacement property not being “substantially similar” if there have been large improvements or changes made to the property between the time it was identified and the ultimate acquisition of the property. Smaller additions to the property, like construction of a fence, are unlikely to challenge the “substantially similar” rule. It is important for the taxpayer to describe any material changes expected to be made to the property on their identification sheet to avoid disqualifying their exchange. Another solution would be for the taxpayer to schedule the changes for after the completion of their exchange and avoid any potential challenges.

What is the 75% rule?

The 75% rule states that if a taxpayer acquires at least 75% of the identified value of a property, then it is considered substantially similar to what was identified. For example, if an individual identifies a property for $1,000,000 and ends up acquiring that same asset for only $750,000, they will still qualify for a tax deferred exchange under the 75% rule since this would be considered substantially similar. If they identified that property for $1,000,000 but only acquired it for $700,000 they would not be protected under the 75% safe harbor rule and their replacement property may not be deemed “substantially similar” to their identified property.

What if I am identifying a DST but would like the option to invest two substantially different amounts?

Some investors may find themselves using a DST investment as part of their 1031 exchange strategy, and the DST portion of their exchange could be two substantially different amounts depending on whether they are able to close on a different acquisition target. For example, they have $1,000,000 to replace and are attempting to buy a new property for $800,000, they will also be investing the $200,000 of boot into a DST. Normally they would identify the $800,000 property and the $200,000 DST and close on both. But what if they are unsure if they can complete the acquisition of the $800,000 property? Perhaps their solution is to invest the full $1,000,000 in the DST in that case. They cannot identify the DST for $1,000,000 and cover the scenario where they only invest $200,000. That would be substantially dissimilar from their identification.

In this case they will need to identify the DST twice: once for $1,000,000 and once for $200,000. As they are also identifying another property for $800,000, their total identification is $2,000,000 and qualifies for the 200% rules and possibly the 3 property rule (if the DST is a single asset).

Importance of the 75% Rule in a 1031 Exchange

Maintaining Compliance

The primary purpose of the 75% Rule is to ensure that the Replacement Property aligns closely with what was initially identified. This alignment is crucial for maintaining compliance with the IRS regulations and securing the tax-deferral benefits of a 1031 exchange.

Avoiding Disqualification

Failing to adhere to the 75% Rule can result in the disqualification of the exchange, leading to potential tax liabilities. Therefore, understanding and applying this rule correctly is essential for investors seeking to defer capital gains taxes.

Practical Application of the 75% Rule

Examples of Compliance

To illustrate the application of the 75% Rule, consider the following examples provided by the IRS regulations:

  1. Barn and Acreage Example: Suppose an investor identifies a property consisting of a barn and several acres of land. If the investor ultimately acquires the barn but with a smaller portion of the land, amounting to 75% of the total value of the originally identified property, this acquisition would generally be considered in compliance with the 75% Rule, provided the nature and character of the property remain unchanged.
  2. Value Discrepancy Example: In another scenario, if an investor identifies a property without any improvements and acquires 75% of the value of the identified property, this acquisition would also comply with the 75% Rule, as long as the nature and character of the property remain consistent.