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How Long Do You Have to Rent a 1031 Exchange Property?

February 18, 2024

The primary goal of a 1031 exchange is to defer capital gains tax. To enjoy the tax benefits, you need to be sure that both properties are like-kind, follow the identification rules, and adhere to the timelines for a 1031 exchange. Beyond these general rules, it’s also important you understand the IRS requirements regarding rental duration for a 1031 exchange property if your exchange involves a rental property.

In the context of a 1031 exchange, the “rental duration” refers to the length of time the replacement property must be rented out or held as a rental to qualify as investment property under the rules of the 1031 exchange.

So, how long do you have to rent a 1031 property to qualify? The Internal Revenue Service (IRS) does not set a specific minimum rental duration for a new property acquired through a 1031 exchange. However, most tax advisors recommend that you hold the rental property for at least two years as a statement of investment intent.

Having been in this industry for over 30 years, we understand the challenges you may face trying to figure out the rules guiding the rental duration of a 1031 property. That’s why we’ve put together this guide to help you understand and navigate the process. If you’re looking to facilitate a compliant, stress-free 1031 exchange, do not hesitate to reach out to our experienced qualified intermediary at Universal Pacific 1031 exchange. Schedule a free call with us today let’s discuss what you need.

This article will help you understand the IRS rules regarding rental duration, how it affects taxes, and the strategies you can employ to meet the requirements.

Legal Requirements For Rental Duration in 1031 Exchange

Legal Requirements For Rental Duration in 1031 Exchange

1. Holding Period

The IRS does not specify a fixed minimum holding period for an investment property involved in a 1031 exchange. A common rule of thumb is to hold both the relinquished and replacement properties for at least one to two years to demonstrate investment intent.

Moreover, if you plan to perform another exchange after the first one, holding periods become particularly examined. So, it’s best to ensure longer holding periods between exchanges to help demonstrate investment intent.

2. Intent to Hold for Investment

The intent to hold the property for business or investment purposes at the time of the exchange is the key factor. The IRS considers the investor’s intent rather than a specific duration. To prove this intent, you may need to document your efforts to rent out the real property and the actual rental periods. Also, recall that the properties must be held for productive use in a trade, business, or investment. Personal use properties do not qualify for deferral of capital gains taxes.

3. Safe Harbor for Vacation Homes

The IRS provides a “safe harbor” rule under Revenue Procedure 2008-16. The rule gives specific conditions under which a vacation home will qualify as property held for productive use in a trade or business or for investment. According to the Safe Harbor rule, the property must be rented to someone else at a fair rental for 14 days or more within two 12-month periods immediately after the exchange. Also, personal use must not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the property is rented at a fair rental.

4. Conversion to Personal Use

If you eventually convert the replacement property to a personal property, it’s important to first meet the criteria for holding it as an investment. While there’s no fixed period after which conversion is safe, a conservative approach would be to follow the safe harbor guidelines to clearly establish the property’s initial investment use.

How Does Rental Duration Affect Taxes?

How Does Rental Duration Affect Taxes?

The Internal Revenue Code, Section 1031 allows real estate investors to defer capital gains taxes by reinvesting the proceeds from selling one property into another like-kind property within a specified time. One of the key factors that determine whether the exchanged properties qualify for tax deferral is the rental duration. This is how it works:

An extended rental duration strengthens the argument that the real estate investor holds the property for rental or investment purposes, meeting the IRS requirements for a 1031 exchange. So, the longer you hold a property for rental purposes, the more likely you will qualify for this tax deferral. On the other hand, holding a property for a short duration before selling it may incur capital gains immediately, resulting in a higher tax liability.

Usually, properties used for rental purposes allow owners to claim depreciation deductions. But that’s different with 1031 exchange properties, where the deferred gain includes the depreciation claimed. However, holding a like-kind property for a more extended rental duration allows for additional depreciation deductions, potentially reducing the depreciation recapture amount upon the eventual sale.

Finally, the IRS assesses the intent behind holding a property. Considering their assessment of investment intent, an extended rental duration demonstrates a clear investment intent, supporting the argument for a 1031 exchange. On the other hand, holding a property for a short period may raise questions about whether the property was genuinely held for investment purposes.

Strategies for Meeting Rental Duration Requirements of 1031 Exchange

Strategies for Meeting Rental Duration Requirements of 1031 Exchange

To successfully defer capital gains tax for a rental property, you need to understand what to do to satisfy the rental duration requirements. Some of the recommended strategies include:

  1. Establish a Solid Rental Agreement: To indicate the property’s use as a rental, set up formal lease agreements with tenants. Such formal agreements add credibility to the investment intent and can be handy for references.
  2. Set a Fair Market Rent: If you set rental prices above or way below current market rates, it may look like the property is for primary residence disguised as a rental. So, set rents within market rates to signify real rental use.
  3. Keep Detailed Records: Always safeguard records of rental listings, communications with potential tenants, and any property management contracts to demonstrate efforts to rent the property. Also, try to maintain detailed documentation of rental periods, including leases, payment receipts, and any other relevant transactions.
  4. Adhere to Safe Harbor Rules: Make sure the replacement property is rented for at least 14 days at fair market value. Additionally, personal use should not exceed 14 days or 10% of the days rented to qualify under the IRS’s safe harbor rules.
  5. Minimize Personal Use: To reinforce the property’s status as an investment, minimize personal use of the property. If you must use the property, ensure it does not exceed the safe harbor limits.
  6. Plan for Long-Term Rental: Plan to rent the property for at least one to two years after the exchange. This duration is not a legal requirement but serves as a guideline to demonstrate investment intent.
  7. Use a Qualified Intermediary (QI): Handling the nitty-gritty of a 1031 tax-deferred exchange can be challenging sometimes. Especially when it involves more complex methods, such as reverse exchange or delayed exchange, you need some level of experience to comply with the rules. That’s why you should contact an experienced qualified intermediary to help you navigate the process successfully.QIs also understand the tax liabilities and other consequences of potential mistakes in rental duration and the exchange in general. So, you can leverage their expertise to ensure your investment properties and transactions are all within the provisions of the IRS for a tax-deferred exchange.
  8. Monitor and Realign Your Strategy: Continuously monitor the rental status of the investment property and make adjustments as needed to ensure compliance with 1031 exchange requirements.
  9. Consult with Professionals: Consult with tax professionals and 1031 exchange experts, like Universal Pacific 1031 Exchange, regularly to stay informed about current laws and strategies that can affect your exchange.
  10. Comply with the IRS rules for 1031 transactions: Beyond the rules that apply to rental duration, it’s also important to understand and follow the general IRS rules when swapping one investment real estate for another. Pay close attention to the replacement property identification rules especially when you’re identifying up to three properties. Learn how to calculate the fair market value of properties so you can be sure that potential replacement properties have equal or greater value than the relinquished property.

Exchanging Your Rental Property?

The key to maximizing the tax benefits of a 1031 exchange is having a proper understanding of the rules you must follow to qualify your rental property. To be sure you’re on the right track, it’s best to consult with a tax advisor and an expert-qualified intermediary. Universal Pacific 1031 Exchange‘s expert insight and guidance will help you stay compliant and avoid costly mistakes. Contact us today for a successful 1031 exchange for rental properties.

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.