One of the many questions that people ask a Qualified Intermediary of 1031 tax deferred exchanges is how long the relinquished property needs to be held to qualify for a 1031 exchange? The answer represents one of many ways to develop a fact pattern that supports a 1031 exchange. As you recall, a 1031 exchange allows the taxpayer to defer or postpone the payment of federal and state capital gains and depreciation recapture taxes, when real property held for the production of income for a business or investment is replaced with real property of equal or greater value than the relinquished property’s net sales price. What is not eligible for tax deferral treatment is a primary residence, Section 121 transaction, or second home.
Dwelling Unit
The IRS released Revenue Procedure 2008-16, effective March 10, 2008, to provide a safe harbor test for dwelling units, vacation homes, and second residences that the IRS will not challenge if the home qualifies for a 1031 exchange. A dwelling unit is defined as real property with improvements such as a house, apartment, or condominium (which accommodates the standard requirements of a kitchen, sleeping room, and bathroom).
Hold Time
The safe harbor test is that the taxpayer must own the relinquished property for at least 24 months prior to the exchange, and in each of those two years, the property must be rented for at least 14 overnights, or 10% of the yearly overnights if greater than 14 personal overnights (including when friends and family stay without paying fair market rent). The replacement property must also be held for 24 months with personal use being no more than 14 overnights each year. One must also rent the property for at least 14 overnights, or 10% of the rental nights if greater in each of the two years. For time used while performing repairs and maintenance, the full day does not count towards personal overnight use.
The 1031 code does not state a hold time. When asked, the IRS said that a two-year hold is sufficient (Rev. Proc. 2008-16 provides the hold time). What about dwelling units held outside the safe harbor? There is limited authority that supports vacation homes or dwelling units that do not meet the 14 rental overnights. Regulation Section 1.1031(a)-1(b) states unproductive real estate that is held by a non-dealer for future use or appreciation is held for investment. Tax court case Newcombe v. Commissioner of Internal Revenue, 54 T.C. 1298, 1302, 1970 WL (1970) supports the taxpayer who “believes that the value of the property may appreciate and decides to hold it for some period after the abandonment of personal use in order to realize, upon such anticipated appreciation, the property can be held for production of income.”
The suggestion is to hold the relinquished property for at least one year and a day to qualify for long-term capital gain. Holding for a shorter period triggers a short-term capital gain tax or the taxpayer’s ordinary income tax rate.
