One of the most important covenants of a 1031 exchange is that the newly acquired property must be held as an investment or for business use.
Primary residences, therefore, don’t qualify for replacement properties in exchanges since they won’t be used for investment purposes. Investors who purchase residential properties to complete 1031 exchanges with the eventual goal of moving into the home must have a strategic plan in place to ensure they don’t invalidate their exchanges and create a taxable event.
In this article we’ll look at the holding requirements for 1031 exchange properties, which should provide a safe harbor for investors who eventually want to live in a home that was part of an exchange.
Overview of 1031 Exchange Rules
Investors seeking to defer capital gains from the sale of investment properties must follow to the letter the rules and guidelines laid out in Internal Revenue Code Section 1031. Any misstep could invalidate the exchange and result in a taxable event.
Investors can defer 100 percent of their capital gains and depreciation recapture tax liabilities by rolling over the entirety of sale proceeds into a like-kind property as part of a 1031 exchange. Like-kind is an extremely loose term – the replacement property can be a different asset type, class, or quality. For instance, you can exchange a duplex for a single-family home, or an office building for a standalone retail building. However, you can’t use the exchange to improve your financial position – basis and debt load must be equal.
There are some important timelines that have to be met as well to successfully complete a 1031 exchange. Mainly, you have 45 days after the close of sale on your relinquished asset to formally identify a replacement property, and you must wrap up the purchase transaction within 180 days total time.
If your goal is to live in the replacement asset, there’s another crucial timeline that must be met.
Two-year Holding Period
How long is the holding period for properties acquired in 1031 exchanges is a common question asked by real estate investors, mostly because the holding period isn’t clearly defined in IRC Section 1031.
The general consensus that can be compiled by sifting through case law regarding 1031 exchanges, along with some additional private letter rulings issued by the IRS over the years, gives investors a sense of how long of a timeline will provide safe harbor before they can consider divesting or changing the use of their 1031 exchange replacement properties.
Generally speaking, if you hold the property for investment purposes for a minimum of two years, that should be sufficient to demonstrate your intent that the property was purchased as an investment and you can fully defer any realized capital gains from the sale of your relinquished asset. This insight comes from an IRS Private Letter Ruling from 1984 that clearly defines the holding period for 1031 exchange properties. Additional insight into safe harbor for holding periods can be gleaned from Internal Revenue Bulletin: 2005-7.
Private Letter Rulings aren’t to be interpreted as law since they are intended solely for the taxpayer to which they are issued. However, this Private Letter Ruling and subsequent issuances from the IRS over time have formed the basis of countless successful exchange strategies in regards to holding times.
Putting it all Together
Real estate investors who want to move into replacement properties acquired via 1031 exchange should rent the property out for a minimum of two years to clearly demonstrate their intent that the property was purchased as an investment. You don’t have to rent the property out full time – 14 days or more within each 12-month period is sufficient, provided your personal use of the property doesn’t exceed the amount of rental time or 10 percent of the total number of days you rent the property out in a given calendar year.
If you decide to divest the property, you’ll have to account for the deferred capital gains and any depreciation recapture that were part of the exchange. However, if you lived in the home long enough and meet ownership and use criteria, you may qualify for a Section 121 exclusion ($250,000 for single taxpayers, $500,000 for married and filing jointly) on the sale of primary residences.
Completing a 1031 exchange can be a complicated process. If you plan on moving into the property after a few years, consider discussing the end goal for your replacement property with a taxation or legal professional with experience in 1031 exchanges to ensure you don’t make any missteps along the way.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
