Perspective and Prescription on the Holding Period for 1031 Exchange

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.