Key #2 To Success in 1031 Exchanges – Holding Period

In the second of seven parts of the “7 Keys to Success Series”, the HOLDING PERIOD of an investment property is next on tap.

At issue is how long a property must be held to qualify as “held for investment” prior to exchanging it, and how long a replacement property must be held after the exchange. While there is no definitive answer in the Internal Revenue Code or from the IRS, some guidelines have been developed through IRS requests of Congress and through court cases. Following these guidelines will provide a considerable degree of safety.

The General Rule: Investment properties should generally be held for more than 12 months (and preferably 18 to 24 months) before being actively marketed or any action is taken to convert the property to personal use. This guideline can be used for both the relinquished property and the replacement property.

The ‘Under One Year’ Exception:
Last week, Eileen Tefft posted a comment on Rain City Guide wondering whether a 1031 property can be held for under a year. In certain circumstances, property can be held for less than a year, but that is an exception to the rule. Thus, what I am about to say is in the very gray area of the 1031 world and I do not accept any sort of liability for your choice to hold the property for less than a year. I usually tell clients the decision to hold property for under a year and then do a 1031 exchange is between them, their Maker and the IRS. That being said, you will definitely want to hold the property for at least two (2) tax years in order to bring up as few red flags as possible to the IRS. Your Form 8824 will ask when the property was purchased and when it was sold, so they will definitely have the dates before them. However, they may not look too closely if they see two tax returns with your property listed, rents received, and depreciation taken. If you are more risk adverse, HOLD HOLD HOLD for at least 12 months! If you like to push the envelope, make sure you hold for at least two tax years.

The inevitable question now coming is: “What if I buy in December and sell in January? Will that still count because I’m holding for two tax years?” My response to that question invariably is, “I can look in the Yellow Pages and find someone who doesn’t care about their future professional life and they may be willing to help you.”

Related Party Exchanges: Another element to the holding period has to do with dealing with a direct swap with relatives or other related parties. This is permissible and the timing is clear: the properties must
be held for two years. If either property transferred in an exchange involving related parties is disposed of within two years, the entire exchange is disqualified. Related parties include family members — brothers, sisters, parents, and lineal descendants — as well as any corporation, partnership, trustee, or other fiduciary relationship where the exchanger owns or controls more than 50%. Related parties must file Form 8824 for two years following an exchange. Specific language should be included to prevent any prohibited action by either party, as failure to follow these guidelines by either related person disqualifies the exchange benefits of both.

General Example: John and Jane Doe own Blackacre as an investment property (let’s say a single-family residence rental). They own the property together as Husband and Wife in fee simple with no encumbrances. The Doe’s have owned and rented out Blackacre for 5 years. They decide that they want to get another rental, but one that is closer to their primary residence let’s say. So, they sell Blackacre doing a 1031 exchange and buy Whiteacre. Two years down the line they move to Ohio and want another rental – but this time So, they sell Whiteacre doing another 1031 exchange and buy Redacre in Ohio.

You tell me, are the Does holding their properties long enough to satisfy the Holding Period requirement of a 1031 exchange?

7 Keys to Success in 1031 Exchanges Series – Key #1 Property Type

In facilitating 1031 like-kind exchanges we have found there to be 7 Keys to Success for investors who most successfully and profitably exchange properties.

The First Key to Success in 1031 Exchanges…Property Type

The first key to a successful 1031 exchange is recognizing the difference between investment property and property held for personal use. Property type is determined by your usage of the property. Section 1031 deals with deferring the taxes on an exchange of property “held for productive use in a trade or business or for investment” and is not applicable for property generally held for personal use.

Section 1031 allows for the exchange of non-owner occupied real property such as a rental home, duplex, apartment building, farm, raw land, or a tenant-in-common interest in an office building. I’ll talk more later about what properties are Like-Kind. Any property that is owner occupied as a primary residence will not qualify for tax deferral under Section 1031 unless there is mixed use in the same dwelling unit. E-mail me if you have questions about mixed use as it can be very complicated. Section 121 deals with primary residences, which have better tax breaks than those for investment properties. Second homes, vacation condos, and recreational lots are part of a special group and are usually considered personal use property and are not eligible for tax-deferred exchange unless personal use of the property amounts to 1) less than 10% of the time the property is rented or 2) no more than 14 days in a year.

So, think money making property and not your primary residence as the type of property that you can do in a 1031 exchange. Discuss amongst yourselves and let me know how I can help flesh out how property types are key in 1031 exchanges.

– Chad