Investors who have used a 1031 exchange to defer capital gains tax on the sale of an investment property know all too well how unbending the Internal Revenue Service (IRS) can be on the requirements to complete a 1031 exchange transaction successfully.
The most notable examples are timeline requirements that an investor identify a replacement property and close on the new property within 45 days and 180 days, respectively, from the sale of the original relinquished property. There are no exceptions, and many exchanges have fallen apart for investors who could not meet this timeline.
But there is another timing issue that 1031 exchangers often ask about. The question, “For a 1031 exchange, do you need to hold the relinquished or replacement properties for a certain length of time?” does not have a simple answer.
Rather than focusing on how long a property is held for purposes of a 1031 exchange, the IRS has focused much of its guidance on the question of how the property is used. We gain insight into the IRS’s intentions from its March 27, 2009 Information Letter , which states:
Section 1031(a)(1) provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is to be held either for productive use in a trade or business or for investment.
In the Information Letter, the IRS further explains1:
Accordingly, § 1031 includes a “holding” requirement that both the relinquished property and the replacement property must be held either for productive use in a trade or business or for investment. . . . [An] exchange of property will not be eligible for deferral of gain or loss under § 1031 if the replacement property is determined to be held by the taxpayer for immediate sale, disposition, or for some other non-qualifying reason. The determination of whether the taxpayer has acquired replacement property for investment purposes is determined by examining the taxpayer’s intent and the surrounding facts and circumstances at the time such property is acquired. This determination is necessarily very factual.
The critical takeaway here is that the properties on both sides of a 1031 exchange – the relinquished and replacement properties – must be held for productive use in a trade or business or for investment. For example, an investor interested in using a 1031 exchange to defer taxes could sell a small industrial facility and replace that investment with a multifamily property. Both assets meet the “productive use” requirement.
As Code Section 1031 is currently written, the length of time required to hold a property to meet 1031 exchange requirements is not specifically defined. The specific facts of each 1031 exchange will determine whether the exchanger has complied with the holding requirement of Section 1031 of the Code. You should work closely with your tax advisors and Qualified Intermediary to help ensure your exchange complies with all of the requirements of Section 1031.
[1] Information Letter 2009-0060. See https://www.irs.gov/pub/irs-wd/09-0060.pdf.