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 or replacement properties in order to qualify for a 1031 exchange. This failure to define a timeframe creates more confusion than any other issue involving 1031 exchanges.
Lack of Definitive Authority on Holding Period and Its Complications
While there are no actual holding rules or regulations, and very little definitive authority on a holding period, some exchange specialists claim there is no set length of time for holding property and that how long or short a holding period is doesn’t matter as long as the taxpayer’s intent is to hold it for investment. On the other hand, there are specialists who believe the magic holding period is a year and a day and still others who believe the holding period to be two years. With all of these modes of thinking, which is correct?
To some degree, all of the above 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.
Not surprisingly, because of the discrepancies relating to holding periods, there have been a number of court cases dealing with the difference between property held for investment and property held for resale. In most of these court cases, the court has ruled that in order to hold a property for investment, taxpayers must hold it for two tax years. This ruling translated 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 the property 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.
Obviously, the ruling of “two tax years” is open to interpretation.
Holding Period Solution
With such a wide perception of what a holding period actually is, confusing and unfair situations have arisen that have created inequality to taxpayers. So, to establish a solution equal for all taxpaying property holders, the IRS has adopted a loose 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 gets them into another tax year, 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 heavily) into long-term capital gains (which are typically taxed more lightly) by doing 1031 exchanges.
If you have questions about the holding period requirements for a 1031 exchange or are unsure of particulars about your situation, please contact us at 949-860-9902, or click here to contact us.