Tick-tock: Minding the Clock in 1031 Exchanges
One of the most common questions we hear is “How long must I own a property before I can do at 1031 exchange?” Unfortunately, this is a pivotal question that cannot be answered simply. Section 1031 of the Internal Revenue Code states that property qualified for an exchange must be “held for investment or used in a trade or business.” At the center of the issue is just what the term “held for investment” means.
The qualifying phrase has two components. The first is the word held, which relates to length of ownership. The second condition of the phrase for investment points to the use or intended purpose of the property.
Before even examining the length of ownership, it may be simpler to examine if the property being considered meets the hurdle of “for investment”. Here the 1031 rules are much clearer. Going with a process of elimination, it’s relatively straight forward to identify what types of uses do not qualify. Three common uses that do not qualify for 1031 treatment are: (1) property held primarily for sale, (2) property that is used as asecond-home only (no rental activity), and (3) primary residences. Primary residences have separate rules for gain exclusion under Section 121, while personal-use second homes do not qualify for 1031 treatment. Property held primarily for sale (that also can be called inventory) includes:
- Land that is developed, subdivided and then sold;
- New homes that are built for sale; and
- Properties that are bought, fixed up and then immediately flipped or sold without renting them out.
Assuming that the property being considered does not fall into any of these disqualified uses, it is wise to next examine what “held” means. Because there is no minimum length of ownership specified in the IRS stipulations or requirements, other sources of information such as Congressional Action, Tax Court rulings, and IRS issuances (Revenue Rulings, PLR’s, etc.) must be considered.
In 1989, Congress discussed inserting a one-year holding requirement, but the proposal did not make it out of the subcommittee. However, it did give an indication. This is consistent with the length of ownership required for long-term capital gain tax treatment instead of the short-term capital gain rate (which is typically at ordinary income tax rates).
The Tax Court appears to consider the intent, rather than the actual time period the property is held, as more important. This becomes apparent when analyzing two similar cases that resulted in very different conclusions. Both center on a taxpayer gifting the replacement property to grandchildren within one year of acquisition. In the first case, the exchanger had discussed, with their grandchildren and their tax advisors, the possibility of making a gift of the property, but made no definitive decision as they were also happy keeping the property. Six months after the replacement closing, they decided to gift the property. The Tax Court ruled in their favor deciding that the general discussions of gifting prior to the acquisition of the replacement property did not rise to the level of invalidating the exchange. In a similar case, the taxpayers made their gift eight months after an exchange. While the taxpayers stated that they intended to hold the property for investment, under testimony, it came to light that the grandchildren had helped in selecting the property to be acquired and had shopped for specific window treatments that would be installed prior to the replacement acquisition. Therefore, the tax court ruled against the taxpayers, deciding that it had been the taxpayers’ clear intent all along to gift this property to the grandchildren rather than hold it for investment.
The IRS issued a Private Letter Ruling in 1984 indicating that a two-year holding period was sufficient. But Private Letter Rulings are not supposed to be used as general guidance; there is no way to know what the IRS might have ruled if the taxpayer had requested a ruling on a one-year holding period or even less. It is important to note, however, that in several Revenue Rulings, the IRS indicated that the immediate sale of a replacement property was not consistent with property held for investment. To that end, there are certain action steps that may be seen as problematic including:
- After acquisition, immediately signing a listing agreement or putting a “for sale” sign on the property;
- Immediately entering into a lease purchase agreement with a tenant; or
- Never leasing improved property.
What should an investor do? Most tax professionals feel that there are no issues exchanging property that has been owned for a two-year period or longer (as long as it was not intended or treated as primarily for sale during this period of time). In fact, most tax professionals feel comfortable that a property can be sold after one year and still qualify for 1031 treatment. As the taxpayer is required to list when the property was acquired and sold on IRS Form 8824 (that is attached to the tax return in the year the exchange took place), the length of ownership is pertinent. It is always advisable for investors to get input from their tax advisers particularly when they are wanting to exchange property has been owned for less than one year. Generally, the shorter the period of ownership, the higher the risk the transaction could be challenged.
Please feel free to contact us if you have questions or want more detailed information on this subject.