A 1031 exchange is a popular tax-deferral strategy that allows investors to swap like-kind properties to defer payment for capital gains taxes. In order to avoid abuse and maintain the integrity of these transactions, many rules exist that investors have to comply with. A widely followed guideline that is encouraged is the 1031 exchange holding period. How does the holding period work and how long is the timeframe?
Below, Realized 1031 has shared a guide to answer the above questions. Keep reading to learn more!
The holding period is the amount of time an investor holds or owns an asset, typically between the day they acquired the asset and the day of the sale. In traditional investments, this time period is critical because it determines how capital gains are taxed. Assets held for more than one year qualify for long-term capital gains treatment, while shorter holding periods result in gains taxed at ordinary income rates.
When it comes to 1031 exchanges, holding periods help demonstrate the investor’s intent to hold the property for investment or business use, as required. There are many rules for like-kind exchanges, such as how the properties swapped must be held for investment or business purposes.
The IRS hasn’t imposed any holding periods for these transactions, which can at times lead to confusion for investors.
Here are some industry benchmarks you can follow.
Given that the IRS has no set holding periods, these numbers must be referenced as guidelines, not hard-and-fast rules. Regardless, consulting with tax professionals is still the best practice so you can determine the best path for your investment strategy.
Following the recommended holding period is just half of the strategy — another critical aspect is proving intent to hold the property for investment or business use. Otherwise, the IRS may assume that you’re leveraging the property for personal use or quick resale while deferring capital gains taxes.
How do you prove your intent?
Here are some other factors to keep in mind in the context of holding periods.
In some cases, investors want to convert a 1031 investment property into their primary residence. Again, the IRS doesn’t have a specific time limit before you can convert the property, but you should still follow the rules set by Section 121 if you plan to take advantage of the tax exclusion.
Other investors may want to convert a primary residence into an investment property. Although the IRS has not issued a formal holding period requirement, many tax professionals recommend holding the property for at least two years after conversion to support the position that it was held for investment purposes. This timeframe helps demonstrate a genuine shift in intent from personal use to investment use, which is a key factor in qualifying for a like-kind exchange.
A “drop and swap” is a strategy where investors holding interests in a partnership or LLC that owns real estate restructure it into a tenancy-in-common, before selling their shares in a 1031 exchange. Most tax advisors suggest a two-year holding period between the restructuring and the sale of the shares. Otherwise, the IRS may view the drop and swap as a step toward liquidation instead of investment or business purposes.
IRS scrutiny doesn’t always happen, but we think it’s better to err on the side of caution when significant capital is involved. If the IRS does end up investigating your 1031 exchange transaction and determines that the property was not held for investment or business use, the exchange may be disallowed. This could result in recognition of capital gains, along with potential interest and penalties, significantly reducing your cash flow and reducing returns.
Another concern is that a questionable exchange could trigger broader IRS involvement, such as a full audit. This may lead the IRS to examine not only the current transaction, but also prior or subsequent real estate activity, particularly if a pattern of short holding periods or inconsistent documentation is identified.
While no specific holding period is required under Section 1031, the IRS evaluates each transaction based on intent and use. The following best practices can help reduce audit risk and support your position in the event of IRS inquiry:
While there is no official IRS-mandated holding period for 1031 exchanges, the amount of time you hold a property can help demonstrate your intent to use it for investment or business purposes—an essential requirement. In general, many tax professionals recommend holding properties for at least one to two years before selling or refinancing, which may reduce the risk of IRS scrutiny. If you’re still uncertain, working with experienced tax professionals can help you navigate the nuanced rules and compliance expectations of a like-kind exchange.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.