rolling 1031 exchanges - holding period

[Lynn Z]

Does replacement property have to be "held" long term or can you improve the property and do another exchange "equal or better" ? Isn't the intent of the law to continue your investment and therefore you are merely continuing your investment if you roll into another investment property? does it matter?

[Bill Exeter]

While the Department of the Treasury Regulations and numerous rulings make it very clear that the Investor must have the intent to hold his property for rental, investment or use in a trade or business, they fail to define exactly how long an Investor needs to hold his relinquished or replacement property in order to qualify for a tax-deferred like-kind exchange pursuant to Section 1031 of the Internal Revenue Code or Section 1.1031 of the Treasury Regulations.

If the Investor’s relinquished property was purchased just before the tax-deferred like-kind exchange transaction, the Internal Revenue Service has routinely taken the position that the Investor actually purchased the property for sale (investory) rather than holding it for investment. Further, the Internal Revenue Service has also taken the position that if the replacement property is sold immediately after the tax-deferred like-kind exchange transaction then it was not held sufficiently long enough to qualify for tax-deferred like-kind exchange treatment.

While there is little definitive authority on the holding period, in one private letter ruling, the Internal Revenue Service has stated that a minimum holding period of two (2) years would be sufficient to meet the Qualified Use test, and a number of court decisions have been handed down that have also taken the same position (although they have been somewhat more liberal than the Department of the Treasury and the Internal Revenue Service).

The amount of time an Investor holds the property is not the only factor the Internal Revenue Service will use to determine whether the Investor had the appropriate intent to qualify for a tax-deferred like-kind exchange, but it is extremely important.

The easiest way to demonstrate the Investor’s intent to hold a property is to do just that: actually hold the property as rental, investment or for use in the Investor's trade or business. The longer the Investor holds the property the stronger his case will be if the Internal Revenue Service questions the sufficiency of the Investors intent.

Tax advisors frequently recommend that Investors hold the subject property for at least one (1) year to prove intent. Holding the property for at least one year will straddle two income tax periods and give the Investor two income tax returns listing rental income, expenses and depreciation, all of which help to provide a solid argument that the Investor had the appropriate intent to hold the property for rental, investment or use in his trade or business.

In addition, the United States Congress at one time considered a minimum holding requirement of 12 months for both relinquished and replacement properties. While the requirement was never enacted by Congress, it does provide a good indication of what sort of holding period Congress would consider sufficient to meet 1031 exchange requirements.

If the Investor is considered a “dealer”, he will typically not qualify for tax-deferred like-kind exchange treatment because technically the property is being held for sale as “inventory” and thus is not property held for investment purposes. In some cases, however, dealers may be able to qualify for tax-deferred like-kind exchange treatment by segregating assets intended to be held as rental, investment or productive use in a trade or business from those assets being held for sale. In these situations, some legal advisors have advised their clients to form a separate entity, such as a limited liability company, specifically to hold title to the segregated property in order to more easily qualify for tax-deferred like-kind exchange treatment in the future.

If however the Investor or dealer’s intent is to buy, fix up and then sell (“Flip”) the property, then he clearly does not have the intent to hold the property for investment purposes. Rather, the intent is to hold the property for sale, and accordingly does not meet the Qualified Use test and will not qualify for tax-deferred like-kind exchange treatment.

The holding issue becomes substantially more complicated when the Investor either holds legal title to the relinquished property, or intends to hold legal title to his replacement property in a partnership, corporation or multi-member limited liability company. The partnership, corporation or multi-member limited liability company can certainly sell relinquished property held in the entity’s name and then purchase like-kind replacement property to be held by the same entity and still qualify for tax-deferred like-kind exchange treatment. The difficulties arise when some of the underlying shareholders, partners or members of the multi-member entity wish to go separate ways and attempt to exchange their interests in that entity as part of a tax-deferred like-kind exchange. If you own property in such an entity, you should seek professional assistance now in order to have time to prepare for a tax-deferred like-kind exchange transaction.

Only the Investor can determine how aggressive or conservative he wants to be in structuring and undertaking a tax-deferred like-kind exchange. The longer an Investor holds a property prior to an exchange, the more conservative the course of action is and the easier it will be to prove the Investor has satisfied the Qualified Intent requirement. Conversely, the shorter the holding period, the more aggressive the transaction is considered and the more difficult it will be to demonstrate that the Investor’s intent was to hold the property for rental, investment or use in a trade or business.