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What is the 75% Rule or “Substantially the Same” Rule in a 1031 Exchange?

Martin Edwards, JD, CES®
06/26/24
This article dives into a lesser-known rule involving the acquisition of identified Replacement Property under the Regulations being substantially the same as identified, known as the “75% Rule”. Gain a better understanding of what qualifies as substantially the same and other considerations around the 75% Rule.
75 Rule

Under the 1031 Regulations, unless Replacement Property is acquired within 45 days from the date of sale of the Relinquished Property , the intended Replacement Property must be identified in accordance with several specific provisions. In addition, consistent with the identification, it is required that “the Replacement Property received is substantially the same property as identified”. The question often arises is to what extent deviations in the property actually received, or acquired, can still constitute as “substantially the same property”. In the context of a Delaware Statutory Trust investment or receipt of conventional property, the amount or extent of the interest received sometimes varies from what is identified, which bring into play the 75% Rule. 

What is the 75% Rule?  

In general terms, the 75% Rule applies to acquiring at least 75% of the Replacement Property that was identified, and if additional considerations are met, that 75% acquired is deemed as “substantially the same property as identified” and therefore the IRS considers it substantially the same as what was identified.  

Exchange companies and others who are frequently involved with 1031 exchanges sometimes refer to this rule as “the 25% rule”, “Substantially the Same”, or the “75% safe harbor”. Since the term “safe harbor” is specifically referenced in the Regulations, but not in this context, the latter statement is not recommended, although is still used by some.  

Examples of the 75% Rule within a 1031 Exchange 

For a better understanding of the 75% Rule, the Regulations provide some guidance, as well as example of the acceptable application of the 75% Rule. Essentially the examples suggest that “nature and character” of the real estate must remain constant, as well as the amount or extent of the property received.   

In one example the property identified consists of a barn and some acreage. The property ultimately received consisted of the barn and a lesser amount of acreage. Due to receiving a lesser amount of land, the payment for the Replacement Property was 75% of the value of the original, full property identified. However, the example provides that “the barn and underlying land differ in nature or character from real property [Q] as a whole” and concludes that it is not the same as the property identified, and therefore is not considered substantially the same.  

An additional example that appears in the Regulations changes the facts above just slightly and addresses value discrepancy. It simply poses a situation where the Exchanger identifies a certain real property, with no barn or improvements, and ends up purchasing less than all of it with a payment of 75% of the value of the originally identified property. Here, the Regulations conclude that the nature or character of the real property did not differ and the “75% of the fair market value” … “is considered to have received substantially the same property as identified”. 

Considerations and Misconceptions of the 75% Rule 

As with many of the nuances around 1031 Exchange s, there are misconceptions around the 75% Rule which need to be addressed. One potential misconception is believing that the above example provides comfort in receiving Replacement Property within a margin of 25% lower or higher than what was identified. At a glance, logic might suggest that if someone identifies a specific property and receives 75% of it or 125% of it, both of those are equivalent, however the latter has not been explicitly confirmed by the IRS. Sometime after the 1031 Exchange Regulations were published in 1991, the Taxation Section of the American Bar Association issued a set of comments on open issues the section members felt would benefit from additional clarity by the Treasury Department. The group raised these issues and also set forth suggested answers that the group believed would constitute an appropriate clarification. Question 11 from the ABA Taxation Section pertained to “substantially the same property as identified” and, in part, the Answer proposed “(B) the fair market value of the Replacement Property on the date of receipt should be no less than 75%, nor more than 125%, of the fair market value of the identified property.” Unfortunately, the IRS did not elect to act in response to this issue or the others covered by the submission. However, it might have furthered the thought that a deviation could be both less or more not exceeding a 25% variance. It should also be kept in mind that when an Exchanger identifies 100% and receives at least 75%, whatever property received was covered by the full identification. However, when 100% is identified up front but 125% is received, by definition the extra 25% was not included in the original 100% designation.  

Another consideration is that the 25% variance applies to the percentage of property identified, which is particularly relevant to the identification of a fractional real estate interest like a DST or tenancy-in-common interest. For example, if the Exchanger identified 3% of DST ABC than the 75% rule applies to only a variance of .75%, which is 25% of 3%. Therefore, to be in accordance with the 75% Rule the Exchanger would still need to acquire at minimum 2.25% of DST ABC to have received “substantially the same property as identified.” 

In summary, the 1031 Regulations provide specific rules in regard to the identification of Replacement Property including the receipt of such property. In regard to the receipt, the property has to be “substantially the same property” as identified. Use of the word “substantially” suggests some flexibility, but at the same time provides ambiguity. The examples mentioned above from the Regulations shed some light on the subject. Specifically, the example involving a property whose “nature or character” has not changed, and at least 75% of such identified property was received, was said to be in compliance with the rules. It is tempting to extrapolate from this example that receiving property that is no more or less than 25%, to the low side or high side, from what was identified is within bounds, but doing so may be making a leap without actual support. 

For those seeking reliable information and premier assistance with a 1031 Exchange , utilizing a national Qualified Intermediary like Accruit can be invaluable. Leveraging the expertise of a trusted Qualified Intermediary as well as our website resources can help you navigate the complexities of 1031 Exchange s with ease.   

  

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.