There are strict timeframes that every investor must adhere to successfully complete a 1031 exchange. However, investors commonly ask, is there a certain amount of time that a property must be held to qualify for an exchange? While the IRS has not explicitly identified a holding period, a few considerations may offer insight.
The 1031 Holding Period
The holding period is how long an investor holds their property. As mentioned, Internal Revenue Code (IRC) Section 1031 does not define how long a holding period must be. Rather, it comes down to the intent of the investor.
The IRS explains: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.”
“Properties are of like-kind if they’re of the same nature or character, even if they differ in grade or quality.
“Real properties generally are of like-kind, regardless of whether they’re improved or unimproved. For example, an apartment building would generally be like-kind to another apartment building. However, real property in the United States is not like-kind to real property outside the United States.”
Section 1031 is designed to enable investors who have held their property for an extended period of time – specifically, those who held the property for income-producing purposes – to trade into another property that would serve the same purpose.
However, not all real estate qualifies because not all is held for the same purpose. The most common example to look at is a primary residence. Since a primary home is not “held for productive use in a trade or business or for investment,” it does not qualify for an exchange. On the other hand, apartment buildings, offices and medical complexes, retail centers and single-tenant assets generally qualify since they are held as an investment.
Developers also face challenges when trying to complete a 1031 exchange. Since a property must be held for investment purposes, buying land, building a property, and selling for a profit often disqualifies the transaction from a 1031 exchange. In this scenario, the property was held to resell for profit, not for investment.
However, investors should consider holding the property for at least one year, if not two, if they are uncertain the property will satisfy Section 1031.
While the IRS has never stated that there is a minimum hold period, there have been situations in which the IRS did not permit an exchange because the owner’s intent was unclear.
Investors uncertain about whether they qualify may generally want to adhere to the two-year recommendation. However, as always, speak to your tax professional to get their professional advice about your particular situation.
The two-year holding period was mentioned by the IRS in 1984 in Private Letter Ruling 8429039. The letter was written in response to an investor who wanted to trade his property via an exchange. The property in discussion was used as the investor’s primary residence until 1981. In 1983, the investor rented the property out. When pursuing a 1031 exchange in 1984, the investor requested a 1031 exchange; the IRS approved, stating that holding rental property for a minimum of 2 years is sufficient to meet the holding period test prescribed by Section 1031. However, a private letter ruling only applies to this particular case and is therefore only considered to be a general guideline for 1031 exchanges.
The one-year holding consideration, on the other hand, was introduced in 1989 when congress proposed a 1-year holding period for a property to qualify for a 1031 exchange. However, this proposal was never integrated into the Tax Code and is therefore not a requirement. Instead, tax advisors have referenced this proposal when determining if a property could qualify under Section 1031.
Another consideration for the one-year holding period is that by holding the property for at least 12 months, the investment will be reflected as an investment property on one’s taxes for two filing years.
These considerations, however, are just that – considerations. Historically, the IRS has made decisions regarding like-kind exchanges that do not align with these proposals. For example, in 1953, in the case Allegheny County Auto Mart v. C.I.R., the court permitted an investor to complete a 1031 exchange after holding property for only five days, whereas in other cases, such as one in 1967 in Klarkowski v. Commissioner, an investor was disqualified even after a six-year holding period.
Does a vacation home qualify?
While most commonly 1031 exchanges are discussed amongst commercial investors, those holding property as a vacation home can typically sell it and purchase a new property via a 1031 exchange. However, the vacation home must have tenants, and the property must be treated in a business-like manner. Furthermore, if the vacation home is acquired as the replacement property, the property must continue to be used for investment purposes. Generally, the home cannot be converted to a primary residence within five years following the exchange.
Other Important Timelines in a 1031 Exchange
To qualify for a like-kind exchange, investors must understand and adhere to the timelines outlined in Section 1031.
Once a property is listed, there is no guideline on how long an investor has to sell the asset. They can sell it on or off-market and market it for one day or five years. In fact, they can list the asset and then change their mind. Up until the property is sold, any gains are unrealized. It is not until the property actually closes that a timeline kicks off, and the investor could be responsible for paying taxes on the realized gains.
When the initial property – or relinquished property – closes, an investor has 45 days to identify their replacement property and 180 days to close. The 180 days also commence from the closing date of the relinquished property. With few exceptions, any exchange that does not meet these deadlines results in all gains being taxable.
Speak to a Qualified Professional
Many 1031 exchanges look different, and for those considering selling their real estate and purchasing a new property via a 1031 exchange, speaking with a qualified professional is highly recommended. Not only can they offer insight on the possible exchange, but 1031 experts can also introduce investors to alternative 1031 exchange investment solutions that may otherwise be overlooked.
Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.
Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.
1031 Risk Disclosure:
- There is no guarantee that any strategy will be successful or achieve investment objectives;
- Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
- Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- Potential for foreclosure – All financed real estate investments have potential for foreclosure;
- Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits