Today we will expand upon Holding Periods and how they pertain to 1031 exchanges.
A holding period, as we defined last week, is simply the period of time one owns an asset before disposing of it. The holding period begins on the day following the day the asset is acquired and concludes on the day the asset is disposed.
The holding period is one of the tests given to a property to determine whether or not the property will qualify to be replaced through a tax-deferred exchange. The holding period will help to identify properties that were used for rental purposes, investment purposes, or use in a trade or business, which are the only permissible uses of property that will qualify as the relinquished or replacement property in a tax-deferred exchange.
Though it is not specifically stated in section 1031 of the Internal Revenue Code, the common understanding is that the IRS will not question the eligibility of a property that has been held for investment purposes for at least two years. Likewise, it is commonly understood that a replacement property should be owned and used for investment purposes for at least two years in order to avoid an IRS challenge to the validity of the 1031 exchange. While some may suggest 12 months is a long enough holding period, two years is the more conservative standard that will reasonably reflect the owner’s intent to hold the property for investment purposes.
Following these holding period guidelines not only allows investors to complete uncontested 1031 exchanges, but also gives them other options for their properties. For example, once the two-year holding period has been met, ownership of a replacement property that is owned through a partnership can be transferred from the partnership to co-tenancy between the individual partners without invalidating the exchange. Also, replacement properties can be converted from properties used for investment purposes to properties used for personal purposes once the two-year holding period has been met. The most common example of this is a rental home that the investor wishes to use as a vacation home or a primary residence. Likewise, a vacation home or primary residence that is converted into an investment property and used that way for two years could then become eligible for an exchange when it is relinquished. For more in-depth information on exchanging vacation homes see: Vacation Homes & 1031 Exchanges.
Flipping properties can be a profitable real estate investment tactic. However, flipped properties cannot qualify for an exchange because they are typically taxed based on regular income tax rates as a result of their short-term nature; therefore, there are no capital gains taxes to defer. Furthermore, flipped properties do not meet the use requirement of an exchangeable property because they are not held and used for rental purposes or in a business or trade.
Paying attention to the holding period of any real estate investment will help you determine how to manage your property to best take advantage of tax deferral benefits.