Understanding The 1031 Exchange Holding Period
Carl E. Sera, CMT
October 15, 2021
A holding period is exactly what it sounds like. It’s the period of time an individual owns a real estate asset before disposing of it. The holding period begins on the day following the day the real estate asset is acquired and concludes on the day the asset is disposed of.
In terms of 1031 exchanges, the holding period is one of the tests given by the IRS to intending taxpayers to determine whether or not their property will qualify to be replaced through a tax-deferred exchange. The holding period will help to identify properties that were used for rental purposes, investment purposes, or use in a trade or business, which are the only permissible uses of property that will qualify as the relinquished or replacement property in a tax-deferred exchange.
Keep reading for a better understanding or feel free to message or call us (443) 332-1031 with your questions! We’d love to discuss the circumstances of your exchange with you.
The IRS and 1031 Exchange Holding Period
If you’re like the majority of investors hoping to defer capital gains tax by doing a 1031 exchange, you may be asking, how long must real estate property be held for investment in a 1031 tax-deferred exchange? This is one of the most asked questions in an exchange transaction. Though the Internal Revenue Code and Treasury Regulations are silent on this issue, a careful analysis of case law yields some principles that can be stated with certainty.
Below are several case laws guiding the issue of holding period of relinquished property in a 1031 exchange transaction. They include:
- If the property a Taxpayer seeks to exchange was acquired immediately before the attempted exchange, then the Taxpayer will be viewed as having acquired that property primarily to resell for profit, not held for investment. (See Revenue Rulings 84-121, 77-337, and 57-244).
- If replacement property is disposed of immediately after the exchange, the property would not be viewed as being held for a qualified purpose (investment) under IRC code section 1031. (See Revenue Ruling 75-292). The congress and courts have been more liberal on the issue of how long a Taxpayer must hold a relinquished property to prove investment intent (See 124 Front Street Inc. v. Commissioner, 65 T.C. 6 (1975)) but tend to agree with the IRS on disqualifying an exchange when the replacement property is disposed of soon after acquisition (See Black v. C.I.R. 35 T.C. 90 (1960)).
However, several private rulings have iterated on IRS rulings regarding 1031 exchange relinquished property holding periods. Some of such rulings include:
- In 1984, the IRS issued Private Letter Ruling 8429039, which indicated that a holding period of two years was acceptable as a holding period to demonstrate the intent to hold for investment. Tax advisors note that private letter rulings do not create a precedent, and some also maintain that a single year is adequate. This means that if your intent is to use 1031 exchanges to immediately flip houses, you can’t.
- Second, in 1989, through HR 3150, the U.S. Congress had proposed that both the relinquished and replacement properties be held for one year to qualify for tax-deferred treatment. Though this timeline was just a proposal, and it was never incorporated into the tax code, some tax advisors nevertheless believe that it represents a reasonable minimum guideline.
Generally, the court has ruled that to qualify as an investment, taxpayers must hold it for at least two tax years. This means that if taxpayers purchased their property on January 1st of one year, they must hold it until at least January 1st of the next year for it to be considered “investment property”. However, the interpretation of “two tax years” could also be translated in the following scenarios:
- If a taxpayer bought a property on July 1st, the property must be held until January 1st of the next year, and likewise,
- Property purchased on December 1st would only need to be held until January 1st of the following year.
Intent to Hold the Replacement property is the Key
The period of time that you hold title to the property, although important, is not the only factor the Internal Revenue Service will use to determine whether you had the intent to hold the property for investment and therefore qualify for 1031 Exchange treatment. The real issue is whether you can prove that you had the intent to hold the property for rental, investment or use in your business.
The easiest way to demonstrate your intent to hold a like-kind property for investment or use in your business is to do just that. You should hold the like-kind property for rental, investment or for use in your trade or business for a sufficient time period. The longer you hold the like-kind property for investment purposes the stronger your case will be if the Internal Revenue Service questions the sufficiency of your intent.
More importantly, the IRS addresses what constitutes a “holding requirement” in the same ruling. Again, there’s no concrete length of time listed but rather language that addresses the exchanger’s intent:
“...An exchange of property will not be eligible for deferral of gain or loss under Section 1031 if the replacement property is determined to be held by the taxpayer for immediate sale, disposition, or for some other non-qualifying reason. The determination of whether the taxpayer has acquired replacement property for investment purposes is determined by examining the taxpayer’s intent and the surrounding facts and circumstances at the time such property is acquired.”
Holding Period Solution
With such a wide perception of the necessary holding period, confusing and unfair situations have arisen. To establish a solution for all property holders, the IRS has adopted a policy of auditing exchanges of periods of less than a year and a day. There are three reasons for the year and a day decision, which are as follows:
- The year and plus one day policy is universal
- It spans two tax years, which complies with previous tax court rulings, and
- Most importantly, the policy prevents taxpayers from turning short-term capital gains (which are typically taxed as ordinary income tax rates) into long-term capital gains (which are typically taxed at lower rates) by doing 1031 exchanges.
Following these holding period guidelines not only allows investors to complete uncontested 1031 exchanges, but also gives them other options for their properties. For example, once the two-year holding period has been met, ownership of a replacement property that is owned through a partnership can be transferred from the partnership to co-tenancy between the individual partners without invalidating the exchange. Also, replacement properties can be converted from properties used for investment purposes to properties used for personal purposes once the two-year holding period has been met.
The most common example of this is a rental home that the investor wishes to use as a vacation home or a primary residence. Likewise, a vacation home or primary residence that is converted into an investment property and used that way for two years could then become eligible for an exchange when it is relinquished. For more in-depth information on 1031 exchange or on how you can do a 1031 exchange to DST, reach out to Sera Capital for proper guidance.