A 1031 exchange is a powerful tax deferral strategy that allows real estate investors to defer capital gains tax when selling one property and acquiring a like-kind replacement property.
What is the 1031 Exchange Holding Period?
The holding period refers to the length of time an investor must hold a property - meaning own - before selling. If a taxpayer buys and sells property too quickly, the property is likely to be viewed as acquired for resale profits and not held for investment according to the IRS. The goal of the holding period is to display to the IRS that the property has been held for investment or business purposes, not personal use.
Minimum Holding Period Requirements
There is no official length requirement for holding/owning a property before deciding to sell in a 1031 exchange. Neither the IRS nor the Treasury set a specific timeline. However, the generally accepted rule is that a holding period of approximately 2 years is sufficient for the property to be considered to be held for investment. This has been established through different court cases and IRS opinions.
While some qualified intermediaries and tax advisors take different stances, it is important to look at the facts and circumstances of each property that is being exchanged.
Typically it is not possible to buy a property through a 1031 exchange and immediately turn around and sell the property again. In this case, the taxpayer is seen as having acquired the property for resale profits and not investment purposes which is not allowed for exchanges.
Exceptions to the Holding Period
Because the holding period does not have an official requirement, there are varying views on the required time. Some advisors believe that one year is sufficient because it is enough time for the investment to appear on tax returns and Congress previously had proposed only a one-year requirement for both the relinquished and replacement properties; however, this bill was never passed.
It is important to note that each exchange is looked at on an individual basis taking into consideration all the particulars of your exchange. Time is only one factor, and intent is extremely important. The two-year minimum for holding the property works in your favor when proving that the property was bought for investment purposes.
Considerations When Deciding to Complete a 1031 Exchange
Timing
When completing a 1031 exchange, it's not only important to adhere to the holding period but also to the strict timeline requirements throughout the process. The IRS has two strict exchange deadlines known as the 45-day identification period and the 180-day exchange period. It's important that you are certain you have identified a property within the first 45 days and completed the exchange within 180 days or the proceeds could be taxable.
Because these dates are in the actual codes section they are inflexible and cannot be extended. There are situations where the Treasury Secretary has extended the date in case of natural disasters in a specific area.
Due Diligence
A qualified intermediary or QI is a third party that facilitates the 1031 exchange for you. It is not the role of the QI to ensure the property is suitable for investment. This falls under the job of the taxpayer to do your due diligence. This can include:
- Property inspection: Assess the property's condition, identify any issues, or estimate any repairs it might need
- Financial analysis: Evaluate the income potential, cash flows, and projected expenses or return on investment, how has the property been report for tax purposes
- Title Search and Insurance: Identify any potential legal issues and obtain title insurance
- Property Records: Review records such as tax assessments, zoning regulations or permits, or restrictions
- Compliance: Ensure the property is compliant with all applicable laws and regulations and determine risks
Professionals such as real estate agents, attorneys, inspectors, and appraisers can assist with all the above activities to ensure that you've thoroughly researched your property.
Tax and Financial Planning
Ultimately, each individual case is different, and in the case that you are audited after an exchange, it is your requirement as the taxpayer to prove that you have held the property for a reasonable amount of time. This is why holding the property for a minimum of 2 years is usually safe. Consulting with your financial or tax advisor can help you determine that you're making the best choice for your financial future.
Understanding the holding period is critical to completing a successful 1031 exchange. As your qualified intermediary, we are excited and ready to help you through the process. To learn more about 1031 exchanges and how to get started, please contact us at (239) 333-1031 and one of our exchange specialists will be able to help. If you're ready to get started today, fill out our form to start your exchange.