How long an investor must own a property before and after a 1031 exchange is a simple question with complex answers.

It might be a year, it might be two years, or it might be dependent on the investor’s circumstances. Because the IRS has never given formal guidance on this issue, investors may want to ask a different question: Will the exchange hold up under audit?

In a traditional real estate transaction, taxes must be paid on capital gains and depreciation recapture. Those taxes are deferred in a 1031 exchange where an investor or business sells one real estate property or properties and reinvests the proceeds in a like-kind investment of equal or greater value. Replacement properties must be identified within 45 days of selling the original investment, and the entire process must close within 180 days of the original sale.

The burden of proving the exchange was done for investment purposes sits squarely on the investor.

Using IRS Language to Infer Answers

The IRS states, “Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts, and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.”   

When determining the length of time that properties must be held, the words “investment and business property” jump off the page. The words are listed forwards and backwards in that single paragraph, indicating the importance of meeting at least one of those conditions rather than a specific amount of time.

Properties purchased months before being included in a 1031 exchange may signal an attempt to sell for profit rather than as an investment. The same would likely be true for properties sold soon after an exchange closes, which could be a red herring that the exchange was simply an attempt to avoid taxes.

Guidance From IRS Actions

The IRS has not issued declarations about how long properties are involved in a 1031 exchange, but there have been hints involving 1031 exchanges that might assist investors.

Some investors believe a property held for at least one year after completing a 1031 exchange will satisfy IRS requirements because it would appear on multiple tax returns. In 1989, Congress proposed HR 3150, which would have specified a one-year holding period for both the sold and purchased properties in a 1031 exchange. While the bill didn’t become law, some tax professionals believe it adds credence to the one-year period because it shows where lawmakers would draw the line.

Others believe properties must be held for two years based on IRS Private Letter Ruling 8429039 from 1984. The ruling indicates holding investment property for two years was sufficient to meet the standard of a 1031 exchange. Still, the letter also clarifies that it was pertinent only to that individual case and did not set a precedent.

The Spirit of the 1031 Exchange Law

Whether investors have one year, two years, longer or shorter likely depends less on previous cases and more on whether the individual investor can show intent to buy and sell real estate as a long-term investment.

If the property was converted into a personal vacation home or primary residence soon after closing, the IRS may void the exchange under audit. However, if the investor can show properties were held for shorter amounts of time than intended because of extenuating circumstances such as healthcare expenses or loss of a primary job, the exchange may hold up under audit. Keeping notes about why decisions were made could also help an investor’s case.

1031 exchanges have been around for100 years, and it’s unlikely the IRS will start issuing formal guidance now about how long properties must be held for. This means it is up to investors to enter into an exchange with the intent to hold properties for the long term, and if plans change, be able to explain why.

Contact us if you have questions related to this article or to get started with a 1031 exchange. As always, we recommend consulting a tax professional related to your individual circumstances.

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