Holding Period for 1031 Exchange Properties
While the Department of the Treasury Regulations and numerous rulings make it very clear that taxpayers must have the intent to hold their 1031 Exchange property for rental, investment or use in their trade or business, they fail to define exactly how long or over what period of time taxpayers must hold their relinquished properties or replacement properties in order to qualify for a 1031 Exchange.
This lack of timeframe creates significant confusion when attempting to structure your exchange.
Impact of Unclear Regulations
Since there are no actual holding rules or regulations and little definitive authority on a holding period, there is significant conflict and confusion about this matter. Some believe there is no actual holding length as long as there is intent to hold it for investment. Others claim taxpayers should hold for a year and day and yet others assert that the proper period is two tax years. So, what is the actual answer?
Unfortunately, it appears that on some level, all of these assertions are correct. Section 1031 rolls the gain from the sale of Old Investment Property over to New Investment Property, tax deferred. Investment property is defined as property "held for investment or used in a trade or business." However, the code section then goes on to state that the code does not apply to property held primarily for resale.
Due to the discrepancies there have been a number of court cases addressing the difference between properties held for investment and held for resale. Generally, the court has ruled that in order to hold a property for investment, taxpayers must hold it for at least two tax years. This means that if taxpayers purchased their property on January 1st of one year, they must hold it until at least January 1st of the next year in order for it to be considered “investment property”. However, the interpretation of “two tax years” could also be translated in the following scenarios:
- If a taxpayer bought a property on July 1st, the property must be held until January 1st of the next year, and likewise,
- Property purchased on December 1st would only need to be held until January 1st of the following year.
Holding Period Solution
With such a wide perception of the necessary holding period, confusing and unfair situations have arisen. To establish a solution for all property holders, the IRS has adopted a policy of auditing exchanges of periods of less than a year and a day. There are three reasons for the year and a day decision, which are as follows:
- The year and a day policy establishes equality for all taxpayers;
- It also spans two tax years, which complies with previous tax court rulings; and
- Most importantly, the year and a day time frame prevents taxpayers from turning short-term capital gains (which are typically taxed at ordinary income tax rates) into long-term capital gains (which are typically taxed at lower rates) by doing 1031 exchanges.
If you have questions about the holding period requirements for a 1031 exchange or are unsure of particulars of your situation holding a property, Hanson & Company would like to help. Contact us at (303) 388-1010 or click here for email for additional information.