Estimating the fair market value of your replacement property in a 1031 exchange is important. There are several potential negative ramifications if you underestimate the fair market value of your properties during a 1031 exchange. In this article, we'll take a look at a recent case study in which a taxpayer had a failed exchange because he underestimated the fair market value of his property.
Underestimating Fair Market Value
In a recent 1031 exchange audit, the California Franchise Tax Board (FTB) partly disallowed an exchange because the taxpayer identified more than 200% of the value of the property sold.
The taxpayer identified five properties during the 1031 identification period. The total value of the identified properties was 267% of the value of the property sold. The taxpayer acquired two properties during the identification period, and another property after the ID period had expired. The total value of these properties was less than 95% of the value of the properties identified.
1031 Identification Rules
Remember, a 1031 exchange needs to abide by the following 1031 identification rules:
During the 45-day identification period, a taxpayer can identify up to three properties, regardless of value.
A taxpayer can identify more than three properties as long as the total value of the identified properties does not exceed 200% of the value of the property sold.
If both of these rules are violated, the taxpayer will be treated as having failed to identify any properties, except:
Any properties actually acquired by the taxpayer during the Identification Period will be considered properly identified; and
All properties identified during the Identification Period will be treated as properly identified if the taxpayer actually acquires properties with a total value equal to 95% of the total value of the properties identified.
In this particular case, the two properties acquired during the ID period were properly identified like-kind properties. The property acquired after the ID period was not like-kind property. As a result, the sales proceeds allocated to this third property were disallowed from the 1031 exchange and treated as boot.
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