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1031 Exchange Holding Period

August 3, 2023

The 1031 exchange holding period refers to how long an investor must hold a property before it qualifies for a like-kind exchange. Naturally, it’s important to understand and adhere to the holding period requirements to ensure you receive the tax benefits of this strategy.

By adhering to the 1031 exchange holding period investors can successfully defer tax on capital gains, reinvest their profits, and increase their purchasing power/portfolio diversification.

This article will explore everything you need to know about the concept of the required holding period in 1031 exchanges.

What Are the Holding Period Requirements for a 1031 Exchange?

A 1031 exchange, also known as a like-kind exchange or Starker exchange, is a mechanism in U.S. tax law that allows real estate investors to defer payment of capital gains taxes on the sale of a property. This is achieved by reinvesting the proceeds of the sale into a new, “like-kind” property.

What Are the Holding Period Requirements for a 1031 Exchange?

The holding period refers to the length of time a property must be owned before it can be eligible for a 1031 exchange. The Internal Revenue Service (IRS) has not specified a certain minimum period that a property must be held to qualify for a 1031 exchange, but the property must be held for investment purposes or use in a trade or business. This is often interpreted as a property being held for at least one year.

Key Time Requirements

There are two key time-related requirements once the exchange process begins:

1. The 45-Day Rule:

After the sale of the relinquished (original) property, the taxpayer has 45 calendar days to identify potential replacement properties. This is known as the identification period. The identification must be in writing, signed by the taxpayer, and delivered to a person involved in the exchange such as the seller of the replacement property or the qualified intermediary.

2. The 180-Day Rule:

The taxpayer has 180 days from the date of sale of the old property, or the due date of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier, to acquire the replacement property. The replacement property must be the same as the property that was identified during the 45-day identification period.

Failure to meet these deadlines may disqualify the transaction from 1031 exchange treatment, resulting in the original sale being subject to capital gains tax.

Common Misconceptions About the Holding Period

Common Misconceptions About the Holding Period

Over time, there have been some inaccurate (and common) misconceptions about the holding period. Here are some of them.

Specified Holding Period

The Internal Revenue Service (IRS) tax code does not explicitly specify a minimum holding period for a property to qualify for a 1031 exchange in the U.S. The requirement is that the property must be held for “productive use in a trade or business or for investment.”

Tax professionals recommend a holding period of at least one year to demonstrate investment intent and to meet the long-term capital gains tax requirements. But it’s important to note that the key factor is not the duration of the holding period, but the intent of the taxpayer when the property was acquired.

The Two-Year Rule

Another prevalent misconception is the ‘Two-Year Rule,’ suggesting that investors must hold the replacement property for at least two years to qualify for a 1031 exchange.

However, there’s a two-year rule in relation to related parties in a 1031 exchange. This rule stipulates that if you execute a 1031 exchange with a related party, both you and the related party must hold the replacement properties for a minimum of two years, otherwise the exchange can be disqualified by the IRS.

A related party includes family members and entities where you have significant ownership. This rule is designed to prevent abuses of the 1031 exchange provision, such as “swapping” properties solely to receive tax benefits.

Factors that Influence the 1031 Exchange Holding Period

Factors that Influence the 1031 Exchange Holding Period

Intent and Activities

For a property to qualify for tax deferral, the IRS monitors the taxpayer’s intent for the purchase of the property and the activities that demonstrate that intent during the holding period.

For example, If you acquired and used a property for investment purposes with a long holding period, the property becomes eligible for a 1031 exchange.

Previous 1031 Exchanges

The holding period of the relinquished property carries over to the replacement property. For example, if you held a property for three years before exchanging it, that three years would be added to the holding period of the newly acquired property.

So, if you decide to sell the replacement property after holding it for two years, the holding period would amount to 5 years.

Practical Guidance for the 1031 Exchange Holding Period

Practical Guidance for the 1031 Exchange Holding Period

Document Your Intent to Hold

Keep relevant investment and business documents to validate the holding period, prove your intent to hold, and establish the eligibility of your asset for a 1031 exchange.

Be Mindful of 1031 Exchange Timelines

Remember that 1031 exchanges have specific time constraints, including 45-day identification and 180-day exchange periods. Adhering to these deadlines is crucial for a valid exchange and proper tax deferral.

Also, holding your property for at least one to two years is recommended to add more credibility to your investment intent.

Use a Qualified Exchange Intermediary (QI)

The major function of the QI is to facilitate the 1031 exchange. Because you are not required by law to receive funds from the sale of tax-deferred property, the QI holds the money for you, acting as a third party between you and the (potential) buyer.

It’s highly recommended to employ the service of a registered QI like Universal Pacific 1031 Exchange to ensure compliance with IRS guidelines and save yourself from being disqualified for tax deferral.

Risks and Pitfalls in 1031 Exchange and the Holding Period

Risks and Pitfalls in 1031 Exchange and the Holding Period

Limited Timeline

To ensure compliance with IRS, you must find a potential replacement within 45 days and complete the 1031 exchange within 180 days. Also, within the tight timeline, you’re required to find a like-kind property using one of the following approaches:

  • Three Property Rule: you can identify up to three like-kind replacements within the 45-day window.
  • 200 Percent Rule: the 200 percent rule allows you to identify unlimited like-kind replacements as long as their cumulative value does not exceed the relinquished asset (that is, they’re not worth more than 2x of your relinquished property)
  • 95 Percent Rule: you can identify more than three properties worth more than 2x of your relinquished property as long as you acquire 95% of the replacement property.

Note that the 45-day timeline is not calculated in business days but calendar days, making it more challenging. Again, the 45-day timeline runs simultaneously with the 180-day exchange completion timeline. In other words, you have 135 days after 45 days of finding a potential replacement.

Failure to complete the process within these two stipulated deadlines results in the incurrence of capital gain tax – an unsuccessful 1031 exchange.

Like-Kind Property Restriction

In the 1031 exchange, you can exchange any investment or business property for another. For example, you can exchange a hotel structure for a shopping complex. However, you can’t exchange your residential home for an investment property, you must prove your intent to hold the property by holding the property for at least 12 or 24 months.

Finding Qualified Intermediary

While it falls upon investors to adhere to the rigid timelines, a Qualified Intermediary (QI) plays a key role in facilitating the exchange process. They take on the task of acquiring your relinquished property and transferring its title to the buyer.

A proficient QI collaborates with you, assisting in managing necessary paperwork and documentation, thus simplifying the process for you. Conversely, an unsuitable choice of QI can amplify your responsibilities and in the worst-case scenario, may lead to a failed exchange.

Universal Pacific 1031 Exchange is equipped to handle exchange transactions across the U.S.

Understanding the 1031 Exchange

Section 1031 of the Internal Revenue Code (IRC) states that no gain or loss shall be recognized if a property held for use in a trade or business or for investment is exchanged solely for a property of like kind.

Basically, this section allows two taxpayers to engage in a tax-deferred direct exchange where the investor relinquishes their property to a buyer in exchange for a replacement property. This exchange must meet the stipulated IRC requirements to qualify for tax deferral.

For example, the properties must be like-kind for the exchange to be tax-deferred. Like-kind properties are assets of the same nature or character regardless of the grade or quality. According to IRS, a like-kind property must:

  • be held for business or investment purposes
  • be held in the United States.

There are various types of 1031 exchanges, which include simultaneous exchange, delayed exchange, reverse exchange, and improvement exchange.

Simultaneous Exchange

In a simultaneous exchange, you relinquish the property and acquire the replacement property at the same time. Hence, your transaction may not qualify for a tax deferral if there’s a delay. Simultaneous exchanges are in two forms: two-party exchange and three-party exchange.

In a two-party exchange, you simply swap your asset with the second party. But in a three-party exchange, you swap indirectly with the second party – meaning that the second party may not have the property at that time but can secure one from a third party and transfer it to you.

Delayed Exchange

In a delayed exchange, you relinquish your property first before acquiring a replacement. So, there’s a time gap between the release of the property and its replacement. This is the commonest type of 1031 exchange transaction as it gives investors more time to secure a more suitable replacement.

Delayed 1031 exchange usually involves the service of a registered independent exchange intermediary, also known as a Qualified Intermediary (QI), such as Universal Pacific 1031 Exchange, to oversee the property sale. The investor transfers his property to the QI and is required to find a like-kind replacement property within 45 days.

Reverse Exchange

Reverse exchange is the opposite of delayed exchange. Here, you purchase the replacement property before selling the relinquished property.

The process requires the investor to buy the replacement property from an exchange intermediary and is expected to relinquish his property within 45 days. After the release, the exchanger completes the sale and closes the exchange within 135 days.

Improvement (Construction) Exchange

This type of exchange allows the investor to improve the replacement property using the deferred tax amount. Improvement or construction exchange is suitable when you need to make necessary upgrades on the property to match your specifications.

Start an Exchange

The 1031 exchange holding period helps the IRS to evaluate the validity of the investor’s intent to hold. To avoid potential disqualification, you’ll need to adhere to the associated rules mentioned above.

Still have questions about the 1031 exchange holding period? Give us a call to discuss your exchange!

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.