What Is the Three Property Rule in a 1031 Exchange?
The three property rule is one of the most commonly used replacement property identification rules in a delayed 1031 exchange. It allows an investor to identify up to three possible replacement properties, regardless of their value.
The Short Answer
The three property rule allows an investor to identify up to three replacement properties during the 45 day identification period.
The value of those three properties generally does not matter under this rule.
That makes the three property rule simpler than the 200% rule for many investors.
Why the Three Property Rule Matters
In a delayed 1031 exchange, investors do not get unlimited time to choose replacement property.
The replacement property must generally be identified within 45 days after the relinquished property is transferred.
The three property rule gives investors a simple way to list backup options without calculating the total value of every property.
Simple Three Property Rule Example
This example shows how the rule works in plain English.
Property Sold
An investor sells a rental property and starts a delayed 1031 exchange.
Three Options Listed
The investor identifies three possible replacement properties before the 45 day deadline.
Value Does Not Control
Under the three property rule, those three properties can generally be identified regardless of value.
One Property Closes
The investor may complete the exchange by acquiring one or more properly identified replacement properties.
Does the Value of the Properties Matter?
Under the three property rule, the value of the three identified replacement properties generally does not matter.
This is different from the 200% rule, where the total value of all identified properties becomes very important.
That is why many investors use the three property rule when they only need one, two, or three backup options.
What Counts as Identifying a Property?
The identification should be in writing, signed by the taxpayer, and delivered to the proper party before the 45 day identification deadline.
A replacement property should also be clearly described.
For real estate, that usually means using a street address, legal description, or another unambiguous property description.
What If One Property Falls Through?
One reason investors identify more than one property is to protect against failed deals.
If the first choice replacement property falls through, the investor may still have other properly identified properties available.
But once the 45 day period expires, the investor usually cannot casually add a new property to the list.
Three Property Rule vs 200% Rule
The three property rule is usually easier to understand.
You identify up to three replacement properties, and their total value generally does not matter.
The 200% rule may be useful when you want to identify more than three properties, but the total value of the identified properties becomes limited.
When Investors Use the Three Property Rule
Investors often use the three property rule when:
- They have one preferred replacement property
- They want one or two backup properties
- They do not need to identify more than three properties
- They want to avoid 200% rule calculations
- They are buying a larger replacement property
- They want a simple identification strategy
Common Three Property Rule Mistakes
- Identifying four properties and assuming the three property rule still applies
- Missing the 45 day identification deadline
- Using vague property descriptions
- Failing to identify backup properties
- Trying to add a new property after the deadline
- Confusing the three property rule with the 200% rule
What Happens If You Identify Too Many Properties?
If you identify more than three properties, you may no longer be relying on the three property rule.
You may need to satisfy another rule, such as the 200% rule or the 95% rule.
If the identification does not satisfy the applicable rules, the exchange can be at risk.
How Investors Reduce Risk
Identify Clearly
Use clear property descriptions, such as street addresses or legal descriptions.
Use Backup Options
Consider identifying more than one property in case the first deal falls through.
Do Not Wait
Treat the 45 day deadline as final and submit the identification early when possible.
Bottom Line
The three property rule is one of the simplest identification rules in a delayed 1031 exchange.
It generally allows an investor to identify up to three replacement properties without worrying about their total value.
The key is to identify the properties clearly, in writing, before the 45 day deadline expires.