In plain terms, a holding period is the amount of time one owns or holds a particular asset before relinquishing it. The holding period is essential to qualifying for a 1031 exchange. Specifically, the holding period must be met before replacement properties can be used for personal purposes like a vacation home or primary residence. In addition, meeting the exchange holding period is key for transferring ownership of a replacement property.
The sections below will help you navigate this real estate regulation by going over what the 1031 holding exchange period is, the purpose of a 1031 holding exchange period, holding period examples and how long you need to hold onto your property to qualify for a 1031 exchange.
What Is the 1031 Holding Exchange Period?
The holding exchange period is a detail of Delaware Statutory Trusts (DSTs) and 1031 Exchanges. The 1031 holding exchange period starts the next day after the asset is acquired and ends when the asset gets disposed of.
More specific to investment properties, the holding exchange period is a test that reveals whether or not the relinquished property will qualify for replacement via a tax-deferred exchange. When selling and replacing property, the property must be held for a certain period of time to qualify for a 1031 exchange for the owner to defer the federal tax that usually comes with real estate.
The holding period helps to show whether a property was used for rental purposes, investment purposes, for business or in a trade. These are the only acceptable uses for qualifying the relinquished or replacement property in a tax-deferred exchange. Although the exact 1031 exchange holding period is not defined, the IRS generally acknowledges two years as a sufficient holding period.
Because the 1031 holding exchange period has significant effects on multiple aspects of owning the asset, you should know everything about your holding period and the ways in which it may impact your overall investment goals. You need to pay careful attention to details such as how long your property is held and the intent behind holding the property to ensure you qualify for a 1031 exchange.
What's the Purpose of the 1031 Holding Period?
Essentially, the 1031 holding period was mandated by the IRS to keep taxpayers from turning short-term capital gains into long-term capital gains. While an asset that is held for less than one year incurs typical or standard income taxes, an asset that is held for a day over one year or more incurs taxes for long-term capital gains.
In other words, short-term capital gains are usually taxed at ordinary income tax rates, whereas long-term capital gains are usually taxed at lower rates. This difference in tax rates makes holding a property for an extended period of time appealing to investors, so their profits are taxed as capital gains instead of being subject to regular income tax rates.
However, it's beneficial to the IRS to require a set time minimum on holding short-term capital gains due to the higher tax rate on these investments. The IRS has done its best to establish equality for all taxpayers by adopting a policy for auditing exchanges. This policy audits exchanges that fall under periods of less than a year and a day. This set time minimum restricts taxpayers from turning short-term capital gains into long-term capital gains and also complies with previous tax court rulings.
Meeting the 1031 holding period standards allows an investor to both complete uncontested 1031 exchanges and gives them an array of options for their properties. For example, after meeting the two-year holding period requirement, replacement properties may be converted to properties owned for personal purposes, and ownership of a replacement property can be transferred between partners without invalidating the exchange. In this way, meeting the IRS 1031 exchange holding period makes life far easier for investors.
Delaware Statutory Trusts Holding Periods and Real Estate Securities
DSTs are complex financial investments that offer investors the opportunity to benefit from property investment gains without being responsible for management. DSTs are considered real estate securities and regulated accordingly. Because securities come with distinct tax advantages and status, DSTs have extra restrictions, such as a prohibition against refinancing and borrowings, that investors should familiarize themselves with.
When it comes to holding periods, DSTs also come with potentially higher risk. The holding period for a DST could be between five and seven years to allow enough time for the real estate asset to build up its value and generate the income needed to meet the security's investment objectives. Despite ownership in the DST being a security, an investor may not be able to dispose of the DST quickly or at all.
If the investment objectives are met before the estimated holding period concludes, trust managers will most likely sell the assets and give the investors back the principal earned to shorten the holding period. On the other hand, if the investment objectives are not met within the specified holding period, managers of the trust will usually have the latitude to extend it to create more time for achieving the yields you want.
However, when managed wisely, DSTs have the potential to be an extremely lucrative investment. Most often, a DST gets dissolved at the pre-determined time, the properties are sold and investors reap the proceeds.
Trust managers must also be aware of the market when considering whether to shorten or extend a holding period. A rising market is better for selling real estate, making the market's peak the ideal moment for selling and earning the highest returns. However, knowing when the market will peak is impossible, and waiting for it to do so runs the risk of buyers leaving the market, resulting in a decline.
On rare occasions, the DST real estate could be held for up to 10 or 20 years. These extended holding periods can be the optimal option for investors searching for long-term stable income investments and potential appreciation.
Investing in real estate securities with a land lease or a ground lease may also warrant a long-term holding period. These types of investments are typically made for the increased income they produce rather than the profit made from selling the investment, making a longer holding period more preferable. Whether you anticipate a holding period of five years, 10 years or longer, thinking through the duration of the hold is imperative for discerning whether investing in a security will align with your investment goals.
Holding Period Examples
There are strict guidelines requiring that a 1031 exchange only be made with like-kind properties or two assets that are similar in nature. However, like-kind can include a wide variety of properties. These types of properties include:
- Exchanging one business property for another, including retail spaces, rental properties, industrial buildings, farmland and raw land.
- Exchanging a property in one state for a property in another state.
- Exchanging one property for multiple properties that have a combined value equal to or more than the original property's value.
- Exchanging a large property for a smaller property.
All properties must be used for investment or business purposes. The IRS limits the use of vacation properties in exchanges and primary or personal residences aren't eligible as part of a 1031 exchange.
Examining holding period examples for these types of properties that are under extenuating circumstances is helpful for understanding the details of a 1031 exchange. Below are three instances of shortened holding periods and whether they would be approved for a 1031 exchange.
1. The Too Good to Pass Up Offer
A taxpayer may sell an investment property and trade it for another investment property if they receive an extremely attractive offer. As long as the facts point toward the taxpayer purchasing the property with the intent to hold it as an investment, such as putting a tenant into the property and not putting the property up for sale, the taxpayer should be allowed to exchange their property and roll the deferred gain into a new property despite a shortened holding period.
However, the taxpayer must prove their initial intent to hold the property as an investment, such as use consistent with investment or a tax history of investment in property. They may have also put a tenant in the property and didn't make a real estate listing or put the property up for sale on their own. The IRS will consider these factors objectively to determine whether the taxpayer's original intention was to hold. If the IRS determines that the original intent was to sell for a profit after a shortened holding period, they will deny a 1031 exchange.
2. The Builder
In general, property flippers, dealers and rehabbers buy or build on property with the intent to sell the finished project. For instance, consider a builder who constructs a chain of condos and sells each one once as they are completed. However, the builder chooses to hold onto one of the completed condos for a couple of years to build rental income before putting the building up for sale with the intent of doing a 1031 exchange.
Even though their original intention was to resell, this builder should be permitted to do a 1031 exchange on this particular building because they used the property for investment purposes. Their original intention is no longer considered in this instance since the builder has used this building for investment.
3. The Drop and Swap
Sometimes, fewer than all of the members in a limited liability company or partnership want to conduct an exchange of relinquished property. Before the sale, the limited liability company or partnership might distribute undivided interests to its members so that each member can choose whether to complete their own exchange or cash out. This approach is known as a drop and swap.
Unfortunately, a drop and swap does not qualify for a 1031 exchange because each member's prior ownership interest in the original entity will not count toward their new individual ownership. Consequently, none of the members can be said to have held the property for use in a trade or business. In addition to holding the asset for a short period, the members also held it with intent for an exchange rather than investment.
How the Unclear Timeframe Creates Confusion
The ambiguous guidelines and special circumstances surrounding how long you have to hold a 1031 exchange property can result in confusion regarding the entire process. While the Department of the Treasury's regulations and past rulings emphasize the need for taxpayers to intend to hold their 1031 exchange property for investment, rental or use in business or trade, they do not clearly define how long a taxpayer must hold their relinquished or replacement property to qualify for a 1031 exchange.
Without an exact timeframe, attempting to structure a 1031 exchange can be challenging for the average taxpayer. The lack of clarity and resulting discrepancies have led to numerous court cases aimed at addressing the difference between properties held for investment and properties held for resale. Some believe the best approach is to hold the property for at least one calendar year.
This approach means that if a taxpayer purchased a piece of real estate on the first day of one year, they must hold onto the property until at least the first day of the next year for it to be called an investment property. One might run into challenges if they attempt to qualify for a 1031 exchange after less than a year because:
- The IRS might think the property was held for the purpose of resale, thus making it ineligible for a 1031 exchange.
- The IRS will try to prevent taxpayers from transferring their short-term capital gains into long-term capital gains.
The general rule of thumb is to hold property for at least two years. This will be easier to prove intent to hold for investment or business use in case of an IRS audit. These unclear regulations grant some validity to multiple theories of how long exchange properties need to be held for, making it exceedingly difficult to determine how long to hold onto property without professional 1031 exchange assistance.
Summarizing Property Eligibility for a 1031 Exchange
Typically, the IRS will not question a property's eligibility if it has been held for investment purposes for a minimum of two years. While there are no regulations that dictate how long you have to hold the property, and one year may be sufficient, two years is your safest bet to avoid any challenges from the IRS.
In this way, owning a replacement property and using it for investment purposes for at least two years means the IRS most likely will not challenge the validity of the 1031 exchange. Although some may consider one year to be an adequate holding period, two years is a more conservative standard for reasonably reflecting the owner's intent of holding the property for investment purposes, which is what most interests the IRS.
Holding a property for a minimum of one year and a day is generally permissible as long as certain other factors are met, such as demonstrated intent of holding the property for investment purposes or in the productive use of a business. Supporting evidence for proving such intent includes having the property managed by a property rental company with rental revenues, expenses and depreciation.
Understanding your holding period and intent standards before attempting to dispose of an asset will help you determine whether the holding period you've had your property for is enough to meet your objective. Evaluate your investment goals to come up with the appropriate amount of time you need to hold a property to achieve your goals.
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