The Department of the Treasury Regulations and others rulings have clearly stated that you must keep your 1031 Exchange property for investment or business purposes. However, there is no specific time defined by these departments as to how long or over what time you must keep the possession of your old properties or replacement properties to qualify for a 1031 Exchange, seeking advantage of the tax-deferral opportunity guaranteed by Section 1031 of Internal Revenue Code.
Asset bought just before your 1031 Exchange
The Internal Revenue Service (IRS) has always questioned the situations when an investor buys the property just before the 1031 Exchange transaction and list it for sale (inventory) rather than holding the asset for rental or business purposes. Besides, the Internal Revenue Service also believes that if the replacement or acquired property is sold soon after the completion of a 1031 Exchange transaction, then in the IRS views, the property was not held for enough amount of time to qualify for a 1031 Exchange transaction.
Barely any fixed authority on holding period
There is no specific holding rules or regulations described by the IRS and hardly any fixed authority on a holding period. However, the Internal Revenue System, in one private letter ruling, has mentioned that a minimum holding duration of two years is sufficient to fulfill the Qualified Use Test. A few court decisions have also acknowledged the same (the court decisions have been more progressive than the Treasury Department and the Internal Revenue Service).
Proving your intent is essential.
Undoubtedly, the time for which you hold the title of your property is important to determine your eligibility for a 1031 exchange. However, it is not the only factor the Internal Revenue Service uses to decide whether or not you had the intent to keep the asset for investment and qualify for 1031 Exchange transactions. The main thing that needs your attention is whether you can prove that you had held the property for use in trade, business, or for investment purposes.
The easiest and perhaps the only way to prove your intent and show IRS that you used the property for investment or use in your business is to do it right away. You must use your current property for rental or business purposes for a sufficient time before opting for a 1031 exchange. In case the IRS questions your intent, the longer you use the property for investment or business purposes, the stronger your chances will be.
Market experts suggest holding the property for a year or more
If you ask a tax advisor, they would often suggest you keep the subject property for at least one year or more to prove your intent to use the asset for investment or business purposes. Keeping the subject property for at least one year means witnessing two income tax periods, which include two income tax returns on rental income, expenses, and depreciation. All of these factors will help you support your argument that you had purchased the property with an intent to use it for rental, investment, or business purposes.
Besides, the United States Congress once suggested a minimum holding requirement of 12 months for both old and new properties. While Congress never enacted the condition, it gives a valid indication of what length of holding period Congress would consider enough to fulfill 1031 Exchange requirements.
Dealers or brokers are not eligible for 1031 exchange benefits.
If you are a dealer or even considered a broker, you will surely not qualify for 1031 Exchange transactions because you are technically keeping the property for sale as inventory and not for investment or business purposes. However, in some cases, dealers can also qualify for 1031 Exchange investments by separating properties intended to be held for use in business, investment, or as a rental from those assets that are held for sale. Under such circumstances, tax advisors suggest their clients that they form a separate entity, such as a limited liability company, particularly to hold title to the separated property to qualify for 1031 Exchange investment in the future easily.
However, if you want to buy, repair, and then sell (flip) the property, your intent is undoubtedly not to hold the property for investment purposes. Instead, it will be considered that you intended to keep the property for sale, which does not meet the Qualified Use test and so, you will not qualify for 1031 Exchanges.
Keeping the property title in an entity or company can complicate the investment.
The holding period issue in 1031 exchanges becomes comparatively more complicated when you either hold the title of the new property or intend to keep to the title of your replacement property in a partnership, corporation, or multi-member LLC. The business, corporation, or multi-member LLC can sell old property acquired in its name and then purchase like-kind replacement property held by the same company and still qualify for 1031 Exchange transactions.
The problem begins when one or more of the underlying shareholders, partners, or members of the multi-member company want to part their ways and try to exchange their interests in that company as part of a 1031 Exchange. If you have a real estate held under such an entity, you must speak to your tax advisor in advance so that you get the time to prepare for a 1031 Exchange.
It’s you who need to determine how aggressive or conventional you want to be in planning and executing your 1031 Exchange. The longer you keep the property title before doing a 1031 Exchange, the more conservative action it will be, and the easier it will get for you to prove your intent behind the investment. On the other hand, the shorter you keep the property, the more aggressive transaction, and more difficult it will be for you to prove that you intended to use the property for rental, investment, or business purposes.