Although it is one of the most useful tools for multifamily real estate investors, the 1031 exchange, which gets its name from Section 1031 of the U.S. Internal Revenue Code, can also be one of the most confusing. The lack of legislative guidance for the procedure, including the putative holding period requirements, is well known. In the absence of clear rules, an investor must fully understand the principles behind the 1031 exchange to avoid potential challenges from the IRS.
What the Holding Period Would Be, If There Were One
Although the phrase “holding period” does not appear in the text of IRC Section 1031, a short length of ownership is one of the main reasons the IRS might call into doubt the qualified use of a relinquished or replacement property in a 1031 exchange. “Qualified use” does not appear in IRC 1031 either, but its meaning is quite clear: “for productive use in a trade or business or for investment.” This excludes the use of exchange property as inventory (that is, for speculative resale or “flipping”) or for personal use, but it allows the use of a property that generates rental income.
Advisers typically suggest that an investor hold a property for a minimum of one to two years. That time frame is based on several indications:
- Congress tried unsuccessfully in 1989 to set a minimum holding period of one year for 1031 exchange properties.
- If a property is held for more than one year, it will feature in two annual tax returns, providing evidence of its qualified use. This evidence might include rental income from the property or its use for business purposes.
- Holding a property for at least a year means that proceeds from its sale will be taxed as long-term capital gains, rather than short-term.
The only minimum holding period requirement specified in Section 1031 is a two-year period for related-party exchanges. The IRS also came out in favor of this longer period in 1984, in a private letter ruling noting that two years is sufficient time to show the intention to use a property as an investment. Private letter rulings do not set precedent, however.
How an Investor Shows Intent to Hold
Due to the lack of formal guidance, questions about the use of a 1031 exchange property are settled individually. As in an audit by the IRS, the burden of proof is on the investor if a 1031 exchange is challenged, and the investor must show his or her intention for the property. An investor can dispute an IRS ruling in court, however. There have been exceptional cases where a property was sold within days of its purchase and found by a court to have been purchased for qualified use, or, to the other extreme, held for several years and found not to be held for investment.
While the use of a property for business purposes might be apparent in many cases (for example, purchasing a building designed to be a retail outlet and using it as such), the intention to generate rental income from a property may be harder to establish if that intention was never achieved or if the investor acted carelessly, such as by putting a rental property to personal use or making changes to a property that are not aligned with the intended use. Either the investor or the IRS might cite the extent of advertising, the rent amount in comparison with the local market rate, and/or property alterations as evidence of intent.
Any non-privileged discussion can be used as evidence, too, by either side. An investor should keep in mind that discussions with a qualified intermediary in a 1031 exchange are not confidential.
An investor’s intention is not always identical to his or her actions. Certain circumstances, such as an unexpected opportunity for investment elsewhere, an unexpected financial reversal, a death, or a change of primary residence made necessary by the investor’s employment, may lead to the sale of a property without invalidating a claim of intended qualified use. Nonetheless, it is a good idea for the investor to exercise caution during these sales in order to avoid the inconvenience of an IRS challenge. While the lack of guidelines around 1031 exchange holding period requirements makes the IRS reaction to a sale unpredictable, an experienced adviser can steer the investor away from many potential problems.
At CWS Capital Partners, we are a fully integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We also own and manage luxury multifamily investment communities in major markets around the country, and employ a team of experts who can help you hone your investment strategy.
For more articles like this one, check out our 1031 exchange blog posts.
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