Suppose you have previously executed a 1031 exchange, selling one property and reinvesting the proceeds into a replacement while deferring the capital gains taxes. In that case, you already know the process requires strict adherence to tight time frames. First, you must identify potential replacement assets within 45 days of the sale and then complete the purchase transaction within 180 days (including the 45 designated for identification.) Meeting this requirement can be challenging, but the reward is the ability to reinvest the entire proceeds from the sale while delaying the need to pay the capital gains taxes.
Once the replacement property transaction is completed, you may wonder how long you need to keep it. After all, one of the requirements of a 1031 exchange is that both properties be used for business or investment. For example, the IRS does not consider flipping real estate as a holding for investment, so a quick remodel and resale of the replacement property would not qualify. If the IRS determines that the use of the replacement property isn’t qualified, the investor will then have to pay the deferred capital gains taxes.
Investors talk about two-year rules and five-year rules related to 1031 exchanges, but are these actual rules? In fact, there is no minimum holding period for a 1031 exchange property, but the IRS and many advisors recommend holding it for at least two years to avoid scrutiny.
The IRS focuses on the investor's intent rather than designating a specific minimum holding period. If the investor can demonstrate their intent to obtain the replacement property for investment or business purposes, they may receive approval for the 1031 exchange. As noted previously, some obvious red flags, like flipping, may result in disqualification.
One reason the two-year period is commonly accepted as adequate is that the IRS specifies a two-year holding period for “related party” exchanges. Related party exchanges typically receive greater scrutiny from the IRS, which seeks to ensure that the 1031 section is not used to gain an unfair advantage. The IRS determined that unrestricted related-party exchanges were sometimes used to achieve basis shifting, which means swapping high-basis properties (with higher tax rates) with lower-basis properties.
Related party exchanges, subject to the two-year holding period, are those in which the buyer and seller of either the relinquished or replacement property are related family members or partners in a company. However, the rule does not include relations with in-laws, step-relationships, aunts, uncles, cousins, nieces, nephews, or ex-spouses.
While the IRS does not specify a particular holding period for exchanges that are not conducted between related parties, the statute does expressly exclude eligibility for exchanges structured to subvert the 1031 exchange requirements. If challenged, the taxpayer may need to prove that they intended to use the replacement asset for business or investment, not for immediate gain through a quick sale or to shift the tax base from a high-basis to a low-basis property. While even a two-year holding period isn't automatically accepted as demonstrating eligibility, it is a good minimum for investors to consider.