Many real estate investors use 1031 exchanges to defer their capital gains taxes and depreciation recapture by replacing a relinquished property with a qualified like-kind replacement property. However, there are a number of very specific rules and timelines that must be followed before you can receive favorable tax treatment through a 1031 exchange.
When planning for their future, investors often wonder whether there’s a specific holding period for their replacement property. Will selling the property too soon cause your exchange to fail? And if so, what is considered “too soon?”
While there are no clear-cut answers to these questions, there are some precedents to help guide your decisions. Here’s what you need to know.
To qualify for a 1031 exchange, the IRS states that both the relinquished and replacement properties must be “held for productive use in a trade or business or for investment.” However, there are currently no specific IRS regulations defining exactly what it means for a property to be “held for investment.”
There is also no specific holding period required for replacement properties. However, holding a property for too short of a time could lead the IRS to question whether you truly intended to hold it for business or investment purposes or if it was held primarily for sale. If it’s determined that the latter is the case, your exchange may be disqualified.
While there are no IRS rules regarding a minimum holding period for 1031 exchanges, the IRS has issued several private rulings that are used to guide decision-making. Revenue Rulings 84-121, 77-337, and 57-244 state that if a property is purchased and then immediately exchanged, it is viewed as being acquired primarily to resell for profit, rather than being held for investment.
In addition, Revenue Ruling 75-292 states that if a replacement property is disposed of immediately after the exchange, it is not seen as being held for investment purposes. Based on these rulings, it’s likely safe to assume that either of these situations could cause a 1031 exchange to fail. If this occurs, the benefit of capital gains tax deferral is lost, and you will owe taxes on the gains from the sale of your relinquished property.
In the past, the courts have been a bit more liberal than the IRS. In the case of 124 Front Street Inc. v. Commissioner, 65 T.C. 6 (1975), the courts agreed that a 1031 exchange could be disqualified if a property is sold too soon, but also noted that an investor may be able to salvage the exchange if he or she can prove investment intent.
When evaluating the early sale of a replacement property to determine whether it meets the requirements for a 1031 exchange, the IRS is likely to consider multiple factors including the taxpayer’s intent, the facts and circumstances that occurred at the time the property was acquired, and any extenuating circumstances that led to the property’s early sale.
In Private Letter Ruling 8429039 (1984), the IRS stated that two years is considered a sufficient holding period to prove investment intent. Some tax professionals believe that a 12-month holding period is sufficient for two reasons. First, this typically ensures that the holding is reflected on two years of tax returns. Secondly, in 1989, Congress proposed HR 3150, which stated that a one-year holding period is sufficient for both the relinquished and replacement properties when engaging in a 1031 exchange. While this was never incorporated into the tax code, some believe it can be used as a guideline for a reasonable minimum holding period.
The differing opinions of the IRS, the courts, and tax experts reinforce the idea that decisions relating to the minimum property holding periods are typically made on a case-by-case basis. When determining whether a property qualifies, the IRS is likely to consider the taxpayer’s intent and the facts and circumstances surrounding the transactions.
Generally, the longer an investor holds a property, the easier it may be to prove investment or business intent. It may be helpful to work with a team of professionals such as an experienced real estate agent, escrow officer, and qualified intermediary to help you create a paper trail that documents your intent. This may help you prove your case if your 1031 exchange comes into question. Since no two exchanges are exactly alike, consulting with seasoned professionals can help ensure you don’t unintentionally disqualify your exchange.
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Because investor situations and objectives vary this information is not intended to indicate suitability or a recommendation for any individual investors.
This is for informational purposes only, does not constitute individual investment advice, and should not be relied upon as tax or legal advice. Please consult the appropriate professional regarding your individual circumstance.
There are material risks associated with investing in real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.
Investment advisory services offered through Bangerter Financial Services, Inc. A state Registered Investment Advisor. Registered Representative and securities offered through Concorde Investment Services, Inc. (CIS), member FINRA/SIPC. Bangerter Financial Services, Inc. is independent of CIS.