Recognizing and Avoiding Common 1031 Exchange Issues – Holding Period
While many aspects of a 1031 Exchange are straightforward and clearly delineated, the holding period of a year and a day is a facet that has been debated, scrutinized and litigated. While not an explicit policy, the IRS has been found to favor exchanges for investment properties that are held for longer periods of time (as opposed to shorter periods of time). However, there are cases where exchanges with shorter holding periods have passed, and there are cases where exchanges involving property held for multiple years have failed. Legal and accounting professionals alike have struggled for decades to determine what an appropriate holding period is.
The confusion about the holding period arises from the ambiguity of IRC 1031, which indicates that investors cannot exchange property held for “resale,” but provides no definition for that term. While the IRS has not defined what it means to hold an investment for “resale” or the necessary holding period for a qualifying exchange, case law and audit results lead prudent exchangers to utilize this type of tax deferral on properties held as a long term investment – and “long term” has been referred to in various revenue rulings to be two years, two calendar years, or two tax years. There is no magical “year and a day” bullet. However, a period of one year and one day does guarantee that the gain from the sale of the property will qualify for capital gains treatment and that the property must be reported on two consecutive tax returns. There have been cases where investors have successfully defended exchanges of short durations by proving their “intent” to hold the exchanged property for long term investment purposes despite some extraordinary circumstance that resulted in a quicker sale – but there is no guarantee that such a strategy will work.
The holding period is a common issue for investors considering 1031 Exchanges as part of their investment strategy. This does not negate the usefulness of the tax tool, but it does make it challenging for investors who specialize in “fix and flip” properties, or investors who are making an acquisition and/or sale with the intent of immediately reselling. It is of particular importance to seek the expert counsel of your investment accountant and attorney as you make these ownership and exchange decisions. Incorporating this requirement strategically and modifying short term business plan execution can help investors avoid undesired tax consequencesir transactions and still make the power of the 1031 Exchange available to them.