A 1031 Exchange is one of the most valuable procedures a serial real estate investor can use to minimize tax obligations when buying and selling property. In a nutshell, the 1031 Exchange allows you to defer capital gains taxes as you replace one property with another.
Section 1031, as defined by the Internal Revenue Service (along with several legal rulings) says that a taxpayer’s intent must be to hold the property for trade and business or investment purposes to be eligible for full tax deferral. However, they fail to specify an exact period an investor must keep the relinquished or replacement property to qualify. If an investor learns a transaction is taxable after the completion of the sale, they risk losing thousands of dollars in capital gains tax.
So what does an investor need to know about the 1031 Exchange holding period to ensure they play by the rules? This article will explore the 1031 Exchange holding period and explain how to ensure you are eligible for full tax deferral.
How Does A 1031 Exchange Work?
A 1031 Exchange provides a tax break for investors who wish to sell a property for business or investment purposes in exchange for a new property used for the same activities. Originally, the 1031 Exchange described a simple swap of two properties between two people. However, it’s rare for an investor with the exact property you want to equally want a property you own.
To accommodate this flaw a third-party exchange process was introduced, involving a qualified intermediary who holds the sale proceeds of the relinquished property. Here is what a basic 1031 Exchange process looks like today:
- The property to be relinquished goes under contract.
- The investor finds a qualified intermediary and enters an exchange agreement.
- The sales contract is assigned to the qualified intermediary.
- Upon the completion of the sale, the qualified intermediary places sales proceeds into an escrow account, and the investor transfers the title of the relinquished property to the buyer.
- The investor must then select three properties suitable as a replacement property and advise the qualified intermediary of their choices within 45 calendar days of the relinquished property sale. In addition, the acquisition of the replacement property must close within 180 calendar days of the relinquished property sale.
- The investor enters into a contract for their desired replacement property.
- The replacement property sales contract is assigned to the qualified intermediary and is closed within 180 days.
- The qualified intermediary transfers escrow funds to the replacement property seller. The investor receives any remaining funds from the escrow account.
- The replacement property title is transferred to the investor, marking the completion of the 1031 Exchange process.
This process can be repeated ad infinitum to defer capital gains taxes indefinitely, provided the investor qualifies for a 1031 Exchange based on a set of rules and regulations.
1031 Exchange Requirements
Investors must meet specific requirements to qualify for the exchange. These include property type and value, acquisition and sale time frames, and the intended use of the building. The following outlines the framework that determines a real estate investor’s eligibility.
- Timing Rules – From the date of the relinquished property sale, an investor must identify prospective replacement properties within 45 calendar days. The replacement property transaction must be completed within 180 days of the original sale.
- Like-kind Exchange – Properties exchanged under Section 1031 must be of “like kind”. Many real estate property assets are considered of like kind, facilitating compliance.
- Replacement Property Identification – There are three ways to identify a replacement property, outlined by the three-property rule, the 200% rule, and the 95% rule.
- Avoiding Taxable Boot – For capital gains tax to get deferred, the taxpayer is encouraged to purchase a replacement property of equal or greater value than the relinquished asset and not receive any cash from the sale. Accepting partial profits could result in a part of the gains getting taxed as boot. The taxpayer selling the relinquished property and acquiring the replacement property must be the same person.
- Holding Period – No minimum holding period is stipulated by the IRS for a 1031 Exchange. However, it’s a requirement that the property gets used for trade or business purposes (such as a rental property). Therefore, a minimum holding period is required to prove the investment intent of both property transactions.
So a sufficient holding period is an integral part of the process for an investor to qualify for a 1031 Exchange, but no specific holding period is laid down in the regulations. Let’s take a closer look at what this means for investors.
What Is The 1031 Exchange Holding Period?
The holding period is the time an investor must hold the property to qualify for full tax deferral under Section 1031. The Internal Revenue Service (IRS) does not specify an exact amount or days, months, or years, though previous tax court rulings can provide some guidance regarding what is deemed acceptable. Investors must be aware of considerations as a buyer and a seller.
In the past, the IRS has issued rulings that an investor must not purchase the relinquished property immediately prior to the 1031 Exchange. In this situation, it appears the acquisition was for resale purposes rather than investment purposes, and the transaction becomes taxable.
For sellers, it’s essential that the replacement property does not get sold immediately following the 1031 Exchange. This may lead to the IRS ruling that the property was not held for trade or business purposes.
To summarize, while the exact holding period is not specified, if an investor cannot prove that the property held was for productive use in business or investment, the 1031 Exchange tax deferral does not apply, potentially costing the taxpayer hefty sums of money.
How Does The Holding Period Affect Investors?
The 1031 Exchange holding period affects how an investor implements business or personal projects concerning the property held. Here are a few instances where you may be affected by the holding period:
- Business Planning: When using a property for commercial use, it’s imperative that your business planning can work around the two-year minimum holding period. For example, if you are a professional investor purchasing commercial real estate with a one-year tenant lease remaining, you must adequately plan to ensure the property will remain profitable for the entire holding period.
- Illiquidity: Capital gains tax can be deferred indefinitely according to Section 1031. But let’s say an unplanned event occurs in 12 months, and as a result, you are required to sell to supplement your emergency funds. Selling your real estate fast would likely already exclude you from maximizing profits in a quick sale. But having to pay deferred capital gains tax on the transaction as well may take the asset out of the running entirely if you find you need cash urgently.
- Investment Returns: Certain investment strategies aim to optimize a real estate asset’s returns over the short term. Finding the right market conditions or an opportunity to add substantial value to a property fast and resell it in the same market are two examples that can motivate an investor to reap short-term capital gain. If this is your approach, a 1031 holding period will probably interfere with your short-term strategy.
What Is The 1031 Exchange Two-Year Rule?
There is a consensus dictating that property held for two or more years can be considered an investment property in a 1031 Exchange. The holding period commencement date is counted from the date of transfer or conveyance of the property.
This requirement does not prohibit the investor from making other real estate transactions. It simply stipulates a longer holding duration for a tax-deferred exchange under Section 1031.
In the case of non-compliance where the investor disposes of a replacement property prior to the two-year holding period, the IRS disallows tax-deferred status. The taxpayer will be liable to pay capital gains income tax and depreciation recapture on the disposed of property.
Where Did The Two-Year Rule Come From?
In a 1984 Private Letter Ruling (8429039), the IRS found that two years was sufficient time to consider a property an investment. Though private letter rulings do not account for a binding precedent, it’s agreed by many tax specialists that two years is an acceptable holding period. The requisite assumption is that the investor intended to hold the property for the purpose of investment.
Certain tax advisors believe that a single year is an adequate holding period for two reasons. The first is that the taxpayer’s tax returns will reflect the asset over two filing periods. The second reason is that in 1989, congress pushed to legally incorporate a minimum one-year holding period for relinquished and replacement properties to qualify for tax-deferred benefits. While this proposal was not accepted, some tax advisors believe it’s enough to go by, at least as a guideline.
Exemptions To The 1031 Exchange Two-Year Rule
There are exemptions to the two-year rule for any property disposed of in advance of the full two-year term, provided the property held is relinquished under one of the following conditions:
- The party who sold the replacement property to you defers their tax liabilities by structuring a 1031 Exchange.
- The transfer occurs after your death or the death of the selling party.
- Both parties in the transfer partially own multiple investment properties and use the 1031 Exchange to own 100% of one property.
- You can provide evidence that the 1031 Exchange was not for the purpose of tax avoidance.
What Is The 1031 Exchange Five-Year Rule?
The IRS understands that an individual’s circumstances can change. Primary residences are not eligible to be purchased or sold with a 1031 Exchange tax deferral. However, the five-year rule – while not a part of Section 1031 – provides guidelines around how a primary residence can qualify for tax deferral under a 1031 Exchange.
The American Jobs Creation Act of 2004 introduced a new five-year ownership requirement for any property used as a primary residence that was originally acquired as a replacement property in a 1031 Exchange transfer. Essentially, you must inhabit the property for a combined two years within five years immediately preceding the date of sale to be eligible for tax deferral in a 1031 Exchange.
How Does It Work In Practice?
Under this law, the tax-deferred gains of a like-kind property do not apply if you sell a personal residence within five years of when you bought it. This rule applies whether or not you use the money from the sale to buy another house. It’s common for taxpayers to use a 1031 Exchange to replace an investment property with a replacement property that they eventually intend to convert tax-free to a primary residence.
Previously, by sequentially cashing out several investment properties in favor of a potential primary residence, property owners could hold the property for investment purposes for one year, then move into the property for two years and sell it tax-free. Naturally, this loophole caused significant losses to tax revenue, so the new legislation endeavored to reduce tax losses. Under this rule, the owner does not have to live in the property for five years – simply owning the residence for a five-year period and living in it for a combined two years qualifies you for complete tax exclusion.
Why Is There A 1031 Exchange Holding Period?
According to Section 1031, the holding period exists to verify that a property transacted is for investment rather than tax loopholes or evasion. Several rulings have been issued by IRS audit procedures, stipulating that if a property was acquired or disposed of immediately preceding or following a 1031 Exchange, the taxpayer’s intent was mainly to flip it for a profit, not hold it for investment purposes.
When the property is no longer regarded as being held for qualified purposes (investment), it’s no longer eligible for a 1031 Exchange. For the investor, this results in a loss of 1031 tax deferral privileges. In other words, you’ll owe the IRS every cent in capital gains tax that you’d planned to reinvest in the replacement property – which could be up to $250k for an individual taxpayer.
From the perspective of the IRS, the holding period’s purpose is to discourage intricate tax planning or tax evasion that results in a significant loss of tax revenue. Instead, the 1031 Exchange should be generally approached as an opportunity for taxpayers to excel in their investment projects by reinvesting capital gains into other real property.
Which Property Does The Holding Period Apply To?
The holding period applies to both the relinquished property and the replacement property. While you may have different methods to prove the investment intent when you purchased either property, you must have sufficient evidence of your intentions to avoid complications in the case of an IRS audit.
Effectively, this means that you will be required to hold the relinquished property for at least two years before exchanging it, and the replacement property for at least two years after exchanging it to access full tax deferral.
Challenges With An Unclear Timeline
The challenges that come with unclear regulations which fail to prescribe a defined holding period are numerous. Chiefly, if there are no guidelines dictating a set period required to hold a property in a 1031 Exchange, how can you be sure that you won’t be disqualified on a technicality and end up owing large sums of money?
The short answer is: you can’t. For this reason, investors considering 1031 Exchanges are encouraged to use a qualified intermediary and consult with a tax advisor or 1031 Exchange specialist who can provide the guidance required to help make the process easier while ensuring the property is eligible for full tax deferral. If you need an experienced 1031 Exchange expert who can generate proven results with 1031 Exchanges, contact the team at NNN Deal Finder to ensure your exchange gets handled with diligence and professionalism every step of the way.
Can I Get A 1031 Exchange Holding Period Exemption?
In most circumstances, you cannot be exempt from the 1031 Exchange holding period. This is to ensure the IRS rewards taxpayers for long-term investment initiatives rather than facilitating short-term capital gains.
According to Section 1031 (f)(2)(C), an earlier disposition of a replacement property may be allowed as a part of a related party transaction, provided the Treasury is satisfied that avoiding federal income tax is not a primary motivator. Since most exchanges involve tax deferral, this situation rarely comes up.
However, there have been rulings where family members exchanged undivided interests in several properties to each own a whole at the end before the two-year holding period had been reached. This is an example of where a holding period exemption may apply.
1031 Exchange Holding Period Examples
To illustrate how 1031 Exchange holding periods operate in action, let’s take a look at two examples of how the time frames have been used effectively and ineffectively.
1031 Exchange Holding Period Used Effectively
Let’s say Mila purchases a commercial real estate property for a long-term hold, profiting from the rental yield and partial business proceeds the tenant generates. After ten years, she decides to sell because she is ready to retire. After a profitable sale, she discovers another commercial real estate building with reduced management requirements. She closes the purchase of the new property within 180 days via a 1031 Exchange to defer long-term capital gains taxes on the property sale and plans to use the rental income to support her retirement.
This is a textbook example of a 1031 Exchange. It’s clear that Mila redirected the exchange funds from one investment property to another and that the relinquished property was held for sufficient time, proving Mila’s intention was to hold the property as an investment.
1031 Exchange Period Used Ineffectively
For this example, we can assume the same scenario as listed above. Only this time, rather than holding the property to support retirement, Mila decides to sell the replacement property after six months and after the completion of the 1031 Exchange.
It’s likely that the exchange will be disqualified, given the short period of time the replacement property was held. It would be burdensome for Mila to provide a convincing case to the IRS proving that she held the property for six months solely for investment purposes. More likely, it appears she is attempting to avoid paying tax on the transaction. The most likely outcome is for the transaction to be deemed taxable.
Section 1031 may be a crisp and clear opportunity for some investors to reap the rewards of long-term capital gains tax deferral when they are involved in real estate investments. For other investors, a lack of direct guidance stipulating exactly how long a property must be held to qualify as a 1031 Exchange property can add confusion and ambiguity to an investment venture.
At best, you can reinvest any capital gains tax owing into a new investment property held for a minimum of two years. At worst, your investment property transactions may be found taxable if the holding timeline is questionable. This can cost an investor a lot.
To ensure a successful journey as you navigate your 1031 Exchange, work with a competent and professional 1031 Exchange expert, such as NNN Deal Finder. They can guide you through every step of the process and ensure that your exchange qualifies for a full tax deferral.