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1031 Exchange Explained: Holding Periods

Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Even so, there are do's and don’ts, and several gray areas of which taxpayers should be aware.
1031 Exchange Explained: Holding Periods

Since 1921, the rules for qualifying and completing 1031 exchanges have gradually broadened and become less restrictive. Even so, there are do's and dont's, and several gray areas of which taxpayers should be aware. A Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary (QI), like Accruit, is accustomed to dealing with all types of complex exchanges, and wants to make sure that the complexity of an exchange doesn't deter you from considering one. Your QI will help you put the pieces together to process an exchange successfully. 

For the taxable gain to be deferred, specific key requirements must be satisfied: 

  • Properties Must Be Held for Business or Investment Purposes:

The relinquished property and the replacement property must be held for business or investment purposes. For example, a sale of business property is not required to be replaced with other business property; it can be replaced with investment property or vice versa.

There are no standard or specific 1031 exchange holding periods by which a taxpayer must abide for property to meet the definition of "like-kind" or held for investment or business use. The only exception is Section 1031 of the Tax Code, with certain limited exceptions, prohibits exchanges where the taxpayer intends to acquire replacement property from a related party. 

Related Party is defined in I.R.C. § 267(b) or 707(b)(1) and generally covers exchanges between family members as well as exchanges between other entities where there is a high commonality of ownership. Section 1031 of the Tax Code, with certain limited exceptions, prohibits exchanges where the taxpayer intends to acquire replacement property from a related party. Related Party is defined in I.R.C. § 267(b) or 707(b)(1) and generally covers exchanges between family members as well as exchanges between other entities where there is a high commonality of ownership. Related Parties are discussed below.

Holding periods are, therefore, determined on a case-by-case basis regarding the taxpayer's genuine intentions based in part on: 

  1. Reasons for acquiring, holding, and disposing of the property. 

  1. The taxpayer's primary occupation. 

  1. Previous 1031 exchange activity. 

  1. Use of the property. 

Generally, the longer the holding period, the better. However, a taxpayer who is disqualified from utilizing the benefits of Section 1031 would not then qualify merely because of a long holding period. What the Code, the courts, and the I.R.S. want to prevent is taxpayers holding property primarily for sale and attempting to defer their taxes utilizing Section 1031 (e.g., a builder of residential subdivisions). 

1031 Exchange Related Party Rules 

When a taxpayer exchanges like-kind property with a related party, the exchange is subject to related party restrictions, one of them being the Two Year Holding Period. When a taxpayer exchanges like-kind property with a related party, the exchange will at least qualify for tax deferral per Section 1031. However, the property received by either the taxpayer or related party must be held for at least two years before it is again exchanged or sold. If either party does not hold the property for at least two years, then the deferred gain or loss from the original exchange must be recognized. (Section 1031 (f)) 

Example: Mr. Jones owns an apartment building in Utah and wants to trade for a vacant rural lot in Wisconsin from his daughter Jane. Suppose either Mr. Jones or Jane sells or disposes of the property received from the exchange within two years. In that case, the deferred gain from the original exchange becomes fully taxable to Mr. Jones on the date of the subsequent disposition.   

A taxpayer is well served by finding an exchange company well-versed in the complexities surrounding 1031 exchanges and the tax law considerations associated with them. As with all matters concerning 1031 exchanges, it is highly advisable to consult with an independent professional regarding any proposed transaction's legal and tax consequences. 

To learn more about the considerations for deferral state tax, we offer a free, no-obligation consultation with one of our subject matter experts.

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