The Internal Revenue Code Section 1031 is very clear about the process investors must undergo to defer recognition of capital gains (and, therefore, to defer paying taxes on those capital gains).
Specifically, you have 45 days from the date you relinquish your asset to find a “like-kind” replacement. And, you have 180 days from the date you relinquish Real Estate A to close on that replacement Real Estate B. These timelines are chiseled in IRS stone, with no exceptions.
However, when it comes to the question of how long you should hold that exchange property before selling it (or exchanging into another), the IRS answer is: “It depends.” While some tax and legal experts suggest that one- and two-year holds are sufficient before selling an exchange property, the true barometer focuses on taxpayer intent.
Intent vs. Timing
The reason why experts suggest the above-referenced holding periods is because they allow you at least a couple of tax-filing years to prove that the property in question is an investment. The one-year holding period also has some legal basis. In 1989, Congress introduced HR 3150, which proposed that both relinquished and replacement properties be held for one year to qualify for tax-deferred treatment. While that particular timeline wasn’t incorporated into the tax code, some advisors believe it represents a reasonable minimum guideline.
Even if your hold period is only for a year, “intent” is the guideline used by the IRS, and focuses on:
- Property usage consistent with investment or business purposes (rather than personal use)
- Tax reporting history demonstrating investment and/or business use of the property
- Extent and nature of your efforts to sell the property (such as listing the property for sale with a real estate agent or broker)
- That the same taxpayer(s) is/are involved with the exchange. In other words, you can’t relinquish an asset for exchange under one entity name, and receive the replacement property under another.
In light of the above, a shorter-term hold on your exchange asset might raise a red flag within the IRS. It could suggest that your intent isn’t to hold the asset for investment, but rather, to flip it for a profit. Failure to prove investment intent can mean, in turn, that the exchange transaction could fail to qualify for the tax deferral.
Another issue when it comes to ending a hold on your exchange property is market timing. Generally, a longer-term hold means your property is less likely to run afoul of market volatility. Commencing an exchange in a recessionary market, or a downturn, means the value of the relinquished and replacement properties could decline; you might have to settle for less to accomplish the sale. However, exchanging in a booming economy has its own issues, namely that finding replacement properties that are reasonably priced (while matching the value of the one you are relinquishing) can be difficult. And either way, selling costs can also have an impact on any profits or gain you might achieve.
Goals, Objectives, and Liquidity
The question that needs to be considered isn’t “how long should I hold my exchange property?” but rather, “what else can I do with that money, other than exchanging it into real estate?” Depending on your financial goals and cash-flow requirements, it might be better just to pay taxes on capital gains, and move the funds into something with better yield and liquidity. By its very nature, a 1031 exchange means you aren’t entitled to any cash proceeds from relinquishing your asset.
Finally, deferring tax payments through an asset exchange isn’t always a sound business plan. The 45-day period to find a like-kind asset, at equal or greater cost, goes by quickly. Investing in bad real estate as a last-ditch effort simply to avoid taxes isn’t a great investment strategy.
Basically, there really isn’t an official “holding period” when it comes to hanging on to your exchange property. The important issues here are your intent (to hold that asset for investment or business purposes, rather than to flip it for a profit) and your financial goals. These aspects, rather than the calendar, should be your determination when it comes time to relinquish your exchange property.
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 offer legal or tax advice. As such, this information should not be used as a substitute for consultation with professional accounting, tax, legal or other competent advisers.
