Probably, the most common questions our firm gets are related to the required holding period for real estate with which clients intend to do a 1031 exchange. A good reason for all these questions is that there is more confusion about this issue than any other issue involving 1031 exchanges.

Some exchange specialists claim that there is no set length of time for holding property -- that how long or short a holding period is doesn’t matter as long as the taxpayer's intent is to hold it for investment. Other specialists believe that the magic holding period is a year and a day. Still others believe the magic holding period is two years. So, which theory is correct?

Actually, to some degree, all of these theories are correct. Section 1031 rolls the gain from the sale of Old Investment Property over to New Investment Property tax deferred. Investment property is defined as property "held for investment or used in a trade or business." However, the code section then goes on to state that the code does not apply to property held primarily for resale.

Not surprisingly, there have been a number of court cases that have dealt with the difference between property held for investment and property held for resale. In most of these court cases, the court has ruled that in order to hold a property for investment you must hold it for two TAX years. This means that if taxpayers bought their purple duplex on January 1st of one year, they must hold it until at least January 1st of the next year in order for the property to be considered investment property. But the interpretation of two tax years could also be that if taxpayers bought their duplex on July 1st they must hold it only until January 1st, and likewise, if they bought it on December 1st they merely need to hold it until January 1st.

Obviously, such a wide difference in holding periods creates a disparity between taxpayers that is confusing and unfair. So, to level the playing field for all taxpayers, the IRS has adopted a loose policy of auditing exchanges of periods of less than a year and a day. Why the year-and-a-day time frame? There are three reasons actually. First, this time frame levels the playing field for all taxpayers. Second, a year and a day, even during leap year, will get them into another tax year; thus it complies with the tax court rulings. And third, and probably most importantly, this time frame prevents taxpayers from turning short-term capital gains (which are typically taxed heavily) into long-term capital gains (which are typically taxed more lightly) by doing 1031 exchanges.

There have been, however, a few court cases in which the taxpayer has been allowed to do an exchange with holding periods of less than a year. A large number of exchangers and exchange specialists like to point to these cases as "proof" that clients don’t need to hold a property for a year in order to do an exchange. However, these short-term advocates miss two important aspects of these cases: the taxpayers had to go to court, a very expensive proposition, and the people who win short-term cases are a minority of the holding period cases.

We suggest clients ask themselves if, as an investor, they really want to pay the heavy costs associated with going to court, knowing that their chances of winning are not good? Our firm and most other good exchange specialists believe that it is grossly misleading and irresponsible to suggest to our clients that short-term exchanges are possible.

Published: November 9, 2005