By Christina S. Porter

As mentioned in last week’s column, investors can significantly lower the risk of a failed 1031 exchange with proper planning and the right resources. Investors need to identify risk tolerance, whether they are looking for appreciation, income or a combination of the two. They need to decide the level of involvement they want with their investments. Do they want an added value property that will take time and energy or one that produces a monthly check with little or no involvement? That is key to a successful exchange.

Any investment has risk. The question is how much and how to most effectively manage that risk. One of the best strategies for managing risk is to diversify. That means spreading the investments out in different locations, different asset classes and different risk categories.

There are three rules for identifying replacement properties when doing a 1031 exchange that need to be considered in the investor’s strategy. Which rule the investor chooses to use will be driven by the investment strategy and replacement properties available at the time of the exchange.

The three rules are as follow:

1. The Three Property Rule: More than 90 percent of the exchanges TM 1031 Exchange is involved with each year apply this rule because of its simplicity and flexibility. The disadvantage is that the investor must limit the selection of properties to a maximum of three. The advantage is that the properties can be of any value and the investor need not close on all them to maintain the eligibility for the exchange. When identifying the three properties, the investor need only clearly identify the properties with their name, address and preferably the assessor’s parcel number (APN).

2. The 200 Percent Rule: The investor can identify any number of properties for which the total fair market value (cash and debt) does not exceed more than 200 percent of the relinquished property. When identifying these properties, the name, address, total value (cash and debt) and preferably the APN are used. This rule is far less frequently used because it limits the total value of the replacement properties and many investors would like to increase the amount of debt to increase available depreciation. It should also be noted that this rule does not allow the investor to materially change the amount of their investment in any one property once identified.

3. The 95 Percent Rule: This rule is seldom used because the investor must close on 95 percent of the total value of all identified properties or the entire exchange will be disqualified. Most investors simply don’t want to take the risk that one of their named properties could fail to close and disqualify the entire exchange.

Using this rule, the investor can name any number of properties of any value. When identifying properties, the value (cash and debt), name, address and preferably the APN need to be submitted to the qualified intermediary.

In summary, the first step in the planning process is to determine the investment objectives and that those objectives are realistic in the context of available properties and the desired risk tolerance. During that process, the above rules should be kept in mind to make sure that the strategy decided on can be achieved in the framework of the rules governing 1031 exchanges.

To avoid problems and the possibility of having a failed exchange, investors are encouraged to start planning prior to the sale of their relinquished properties.

While it is better to pay the taxes than to make a bad investment, with proper planning and resources there is no reason that the investor can’t successfully complete their exchange and realize the benefits of diversification (reduced risk), improved cash flow, and eliminate management headaches.

Investors are encouraged to consult their tax advisor and/or legal counsel when contemplating doing a 1031 exchange.

(You can reach Christina Porter at 1-877-4 TM 1031, or e-mail her at christina@tm1031exchange.com to discuss your specific needs. TM 1031 Exchange assists investors in planning and executing successful real estate investment strategies. Visit www.tm1031exchange.com for a complete list of investment properties and to download the TM 1031 Tool Kit. TM 1031 Exchange successfully did over $100 million of 1031 exchanges in 2005.).