A 1031 exchange allows you to enjoy tax-deferral benefits as you reinvest proceeds from a property sale into another like-kind asset. However, the IRS does require you to hold the acquired property for business or investment use. This rule can impede people who may want to convert their assets later, such as turning a rental property into their primary residence. In this blog post, Realized 1031 discusses how long a 1031 exchange needs to be rented to maintain your tax-deferred status and avoid IRS scrutiny.
A Refresher on 1031 Exchange Rules
There are several rules the IRS imposes to avoid abuse of 1031 exchanges. These include the 180-day timeframe and the equal-or-greater-value requirement. In this discussion, the most significant stipulation is the qualified use requirement, which mandates that both the relinquished and replacement property must be held for productive purposes — investment, trade, or business operations.
Why Do Rental Periods Matter?
Showcasing your intent to hold the acquired property for investment is key in 1031 exchanges. If the IRS thinks that you swapped it for personal use, then the service may disqualify you from your tax-deferred status. One way to demonstrate your intent is by renting the property for a given period to third parties at fair market value. This practice satisfies the qualified use requirement and lowers the chances of IRS investigation.
So, how long should you rent the property? The IRS hasn’t provided any strict guidelines regarding the length, but most experts agree that one to two years is acceptable. This recommendation is based on practical experience and IRS guidance related to similar scenarios, including Revenue Procedure 2008-16, which provides a safe harbor for vacation homes used in a 1031 exchange.
Revenue Procedure 2008-16: 1031 Exchange Safe Harbor Rules
What about second homes or vacation homes that you intend to sell in a 1031 exchange? In this case, Revenue Procedure 2008-16 applies. This ruling provides safe harbor language that helps qualify these types of properties for 1031 exchanges. To meet this safe harbor, the following conditions must be satisfied for each of the two 12-month periods immediately preceding the exchange:
- You must have owned the property for at least 24 consecutive months before the exchange. This is the 1031 exchange 2-year holding period.
- You must have rented the property for at least 14 days annually in the preceding two years, and the rent must follow fair market values.
- You must not have used the property for personal use for more than 14 days during the past two years or 10% of the total number of days you rented the property. Personal use includes occupancy by friends or family unless they were paying fair market rental rates.
What Happens If You Sell or Convert the Property Too Soon?
In this case, the IRS may argue that you didn’t exchange it for investment or business use. They will examine factors such as the reported rental income and the presence of long-term lease agreements. If the service proves that you failed to follow one core tenet of the 1031 exchange through a “facts and circumstances” test, you may lose your tax-deferred status and be compelled to pay capital gains taxes.
Wrapping Up: Length of Rental Period for 1031 Exchange Properties
While the IRS does not have a strict requirement for 1031 exchange rental lengths, one to two years is generally recommended for replacement properties that will be later converted into primary residences. For relinquished properties, particularly second homes or vacation rentals, at least 14 days per year is required.
If you want to learn more about these various rules surrounding rental lengths, we’re here to help. Contact Realized 1031 today to schedule an initial consultation.
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.
Sources:
https://www.irs.gov/taxtopics/tc701
https://www.ipx1031.com/wp-content/uploads/2019/03/IPXtopic_RevenueProcedure_2008-16.pdf
