We provide informational workshops for a variety of professionals including real estate brokers and agents. Real estate agents who do not deal with 1031 tax deferred exchanges frequently will ask many questions.
February 9, 2023
By Al DiNicola, AIF®, CEPA ™
adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD, LLC
Recently we received a call from a real estate broker (licensed in Florida for over 30 years) on how long you need to keep a property before you do a 1031 exchange. It is a valid question on a topic that may be misunderstood. There are a variety of aspects to understanding how long you need to hold a property or what is known as the holding period. (Delaware Statutory Trusts (DSTs) qualify for 1031 exchanges and typically satisfy the holding period as well as other IRC requirements. However, DSTs are not included in this article).
The Importance of the Holding Period
If you are asking for the holding period, we need to understand when your interest in the real estate began. Typically, the day after you close on your property is considered the start of your ownership interest in the real estate. As an example, if you closed on a property January 15, 2023, your ownership interest would begin (for holding period calculations) on January 16, 2023. The ownership clock would conclude on the day you sell the property.
Testing, one, two, three
There are a few tests that the IRS established to determine if your exchange complies with the intent of IRC Section 1031. The holding period test may affect the property you are selling as well as the property you are acquiring. Back to the question from the 30-year real estate veteran. The question was “can we purchase a commercial property and sell the property in about 6 months utilizing a 1031 exchange?”. The broker was intending on acquiring the commercial property, fixing the property, or upgrading the property and then putting the property on the market for sale. Some in the industry refer this to “flipping”.
- He calculated it would take about 6 months for the improvements. The IRS is very specific as to what the intentions should be or must be for the property. The property must be purchased for investment purposes that are used for rental or in a trade or business. This would be the starting point for the discussion. What was your intentions when you purchased the property.
- Meeting this qualification (intent) checks one of the boxes on having your property qualify or being accepted as a 1031 tax deferred exchange. Meaning: if you “flip” the property quickly after purchase, the IRS may conclude that you didn’t intend to hold the property for investment, and they could invalidate your exchange!
So, what is the prescribed holding period?
The 1031 exchange may have been the buzz word from many investors for decades (1031 has been around for over 100 years). The benefit of the 1031 exchange is the deferral of capital gains taxes to a later date. The question is “what is the time period: 6 months, one year, two years or some other time period”. We have seen this question in emails and attempted to answer the question over the phone. If you attempt to look up the time period within the IRC code, you will be hard pressed to find the answer. Typically, you will find an array of answers in rulings or case laws (reflecting other taxpayer attempts) to locate an answer.
Shedding light on the holding time period.
Flippers are excluded. If you are purchasing a property (as the broker above intentions were to do) with the intent to resell then you are not in compliance with the intent of the 1031 exchange guidelines. In this case you are not acquiring the property for investment but for what has been referenced as a flipped property. Many flippers focus on residential properties, but commercials properties may be viewed as a property that may be flipped. You need to hold the property for investment. (This is covered in Revenue Rulings 84-121, 77-337, and 57-244 and covers the issue of intent).
Immediate disposition not permitted.
Here is another situation. An investor held a property for investment for a number of years as a rental property. The investor enters into an agreement with a qualified Intermediary (QI) that is needed for a 1031 exchange. The investor’s investment property sells and closes, and the proceeds are being held by the QI. The investor sells the newly acquired property within a matter of weeks (viewed as immediately) . In this specific case the newly acquired property would jeopardize the exchange because the replacement property was not being held for investment purposes. (This is referenced in Revenue Ruling 75-292 and addresses productive use intent). How does congress view the situation of holding period. The courts (and congress) have been more liberal on proving investment intent and the issue of how long a Taxpayer must hold a relinquished property. (This is covered in a case of 124 Front Street Inc. v. Commissioner, 65 T.C. 6 (1975). The IRS disqualified the exchange when soon after acquisition the replacement property is disposed of. (This is further demonstrated in 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.
Private Letter Rulings but not the Law
There was a Private Letter Ruling 8429039 in 1984, which acknowledged or indicated that two years was acceptable as a holding period. The two-year holding period demonstrated the property was held for investment. Private letter rulings, according to tax advisors do not create a precedent. Actually, some tax advisors indicate a single year is adequate. This means that if your intent is to use 1031 exchanges to immediately flip houses, you can’t.
Who said one year?
The U.S. Congress had proposed, in 1989, through HR 3150 that holding both the relinquished and replacement properties for one year would qualify for tax-deferred treatment. This was a proposal for a holding period. Unfortunately, this (clear time period) was not incorporated into the tax code. However, there are many tax professionals who believe this one-year holding period does represent a reasonable minimum holding time period guideline.
Opinions Matter
What appears apparent is there are differing opinions the IRS, courts and legislature maintain regarding whether a property is held for investment and may be made on a case-by-case basis. Each taxpayer’s individual situation will be reviewed, and all the circumstances and facts will be taken into considerations. The taxpayer, if audited, will have the burden of proving his intent. The burden of proof will be on the intentions when the replacement property was purchased, or how the taxpayer/investor acquired the relinquished property. The intention meaning was the properties held for investment or business. The holding time period is just one factor that the IRS and courts will consider in determining the Taxpayer’s intent. The other consideration may be if the purpose or intent can change while the taxpayer holds the property. The longer the property is held by the taxpayer proving the intent of holding the property for investment becomes easier.
Exceptions, exceptions
There are always exceptions to these guidelines that push the extremes. What seems to be counter to all of the previous text there has been approval of an exchange when the relinquished property was held for only five days (See Allegheny County Auto Mart v. C.I.R. 208 F2d 693 (1953)). In another situation there was an exchange not permitted when the replacement property was held for six years (Klarkowski v. Commissioner, TC Memo 1965-328, affd on other grounds (7th Cir. 1967) 385 F2d 398). The intentions of the taxpayer may be the center of the focus.
Who said two years?
So, the question arises has the court ruled that you need to hold for two years to qualify as an investment. To add to the confusion the answer may be yes and no. If we use the date mentioned in the top of the article of January 15, 2023, you need to hold until January 16, 2024, to be considered investment property. In this example there are two different tax years (2023 & 2024) where the taxpayer investor may report on their tax returns acquisition, income & expenses (2023) and disposition (2024). However, what if you purchase the property in June of 2023 and sell in January 2024? As mentioned, each case or challenge is based on individual situations, and it could all come back to what was the intent when purchasing the replacement property.
The IRS will use several criteria if there is a review of your exchange. One would be the time the property was held and just as important would be the investor intent. Was your intent to hold the property for investment? The burden of proof will be on the taxpayer to provide adequate support of the intentions to hold for investment or business purposes.
Specific Use is the Proof.
So, what is best way to provide proof that your investment property was use as a rental or business? Have the property used for that specific purpose. The 1031 tax deferred exchange vehicle permits a taxpayer to exchange for like kind property. That would include a property used in a trade or business or rental property. If challenged the longer you have held the property, the better for you providing proof to the IRS. It may all come down to what was your intent.
Many advisors believe the IRS continues to be vague on the exact time period or what is references as holding period. This will enable the IRS, on a case-by-case basis, to review the intent of the exchanger taxpayer.
Perspective and prescription
No doubt there are a variety of perspectives on the actual time period for holding a property prior to entering into and executing an exchange. Yes, it can be considered confusing and contradictory at times. What we have seen is a pattern of exchanges that are review by IRS. Exchanges that happen in less than a year and a day seems to be the target for review. While there is no guarantee you will not be the subject of review if longer than a year and a day there are reasons to support that position.
It is settled one year and a day (but it depends)
- The universal advice by CPAs and other 1031 experts is one year + one day.
- There have been in the past rulings that support spanning two tax reporting periods. For most taxpayer investors the treatment of the gain may be most important. Holdings over a year are treated as long term gain rather than short terms gains. Long term gains are taxed at a more favorable rather than short terms gains which are taxed as ordinary income. The 1031 exchange defers the gain unit a later time.
- The ultimate goal of investors is to execute an exchange that is fully supported by intent as well as a holding period that cannot be challenged by the IRS.
One parting thought to be continued.
We will cover converting rental properties into second homes and primary residences in future articles.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
This is not an offer to purchase or solicitation to purchase any security, as such be made only through an offering memorandum or prospectus. Investing in securities, real estate, or any investment, whether public or private, involves risk, including but not limited to the potential of losing some or all of your investment dollars when you invest in securities. You should review any planned financial transactions that may have tax or legal implications with your personal tax or legal advisor. NAMCOA, LLC is a Registered Investment Advisor, regulated by SEC (Securities and Exchange Commission). Our corporate office is located at 999 Vanderbilt Beach Road, Suite 200, Naples Florida 34108. Securities Offered through MSC-BD, LLC, Member of FINRA/SIPC. 8215 SW Tualatin- Sherwood Rd, Suite 200, Tualatin, OR 97062. MSC-BD, LLC and NAMCOA are independently owned and are not affiliated.
Thank you.
