Understanding a "Like-Kind" Exchange's Holding Period

Every investor must adhere to rigorous deadlines in order to effectively conduct a 1031 exchange. However, investors frequently inquire as to whether a property must be held for a specific period of time in order to be eligible for an exchange. Although the IRS hasn't stated a holding time specifically, a few factors could shed light on the matter.

During the 1031 Holding Period

How long an investor keeps a piece of property is known as the holding period. IRC Section 1031 does not specify the length of the holding period, as was previously indicated. Instead, it depends on the investor's goals.

No gain or loss shall be recognized on the exchange of property held for productive use in a business, according to the IRS.

"Even though properties vary in grade or quality, they are still of the same sort if they have the same nature or character.

Whether they are renovated or unimproved, real estate properties are often of a like kind. An apartment building would often be similar to another apartment building, for instance. However, real estate within the United States is not comparable to real estate outside.

like-kind-exchange-holding-period-1031-exchanges-New-York-investment-strategies-retirement-planning

Recognizing Intent

The goal of Section 1031 is to make it possible for investors who have owned their property for a long time, particularly those who did so for income-producing purposes, to exchange it for another property that would serve the same function.

Since not all real estate is owned for the same purpose, not all of it is eligible. A primary residence is the most frequent case that should be considered. A primary residence does not qualify for an exchange since it is not "kept for productive use in a trade or industry or for investment." On the other hand, because they are held as investments, residential complexes, office and medical buildings, shopping malls, and single-tenant assets typically qualify.

In order to achieve a 1031 exchange, developers must overcome additional obstacles. Purchasing land, constructing a property, and then selling it for a profit frequently disqualifies a transaction from a 1031 exchange since a property must be held for investment purposes. In this case, the property was held for profit-making purposes rather than as an investment.

If investors are unsure whether the property will satisfy Section 1031, they should think about holding it for at least one year, if not two.

Even while the IRS has never explicitly said that there must be a minimum hold period, there have been instances where the IRS refused to allow an exchange because the owner's intent was ambiguous.

Investors who are unsure of their eligibility may choose to follow the two-year advice in general. However, as always, consult with a tax expert to receive their opinion on your specific case. The IRS referred to the two-year holding term in Private Letter Ruling 8429039 from 1984. The letter was written in response to a request for an exchange from an investor who wished to sell his property. Until 1981, the subject property served as the investor's primary residence. The investor leased out the property in 1983. The IRS granted the investor's request for a 1031 exchange in 1984, noting that keeping rental property for at least two years satisfies the holding period test required by Section 1031. But since a private letter ruling only applies to this specific instance, it may only be regarded as a general recommendation for 1031 exchanges.

The one-year holding consideration, on the other hand, was first proposed by Congress in 1989 as a requirement for a property to be eligible for a 1031 exchange. However, because this suggestion was never included in the Tax Code, it is not necessary. Instead, in order to determine whether a property would be eligible under Section 1031, tax professionals have referred to this idea.

The fact that the investment will appear on one's taxes as an investment property for two filing years if it is held for at least a year is another factor for the one-year holding period.

Nevertheless, these factors are but that—factors. In the past, the IRS has made choices on like-kind exchanges that do not support these ideas. For instance, in the case Allegheny County Auto Mart v. C.I.R. from 1953, the court allowed an investor to complete a 1031 exchange even though they had only owned the property for five days. However, in other cases, like Klarkowski v. Commissioner from 1967, an investor was still ineligible even after six years of ownership.

Is a vacation home acceptable?

Those who own property as a vacation home can often sell it and buy a new property via a 1031 exchange, however this is typically how commercial investors talk about 1031 exchanges. The vacation home must, however, have tenants, and it must be managed like a company. In addition, if the vacation home is purchased as the replacement property, the investment-related use of the property must continue. The property can usually not be turned into a primary residence within five years of the exchange.

1031-exchanges-NY-investor-relations-real-estate-retirement-planning

Additional 1031 Exchange Timelines That Are Important

Investors must be aware of and abide by the deadlines specified in Section 1031 in order to be eligible for a like-kind exchange.

There is no time limit on how long an investor has to sell an asset after it is put on the market. They can market it for one day or five years and sell it on or off the open market. In reality, they have the option to list the asset before deciding otherwise. Any gains are unrealized until the property is sold. A timetable doesn't begin until the property actually closes, and the investor may be liable for paying taxes on the realized gains.

An investor has 45 days to choose their replacement property and 180 days to close after the initial property, or surrendered property, closes. The 180-day period begins on the same day as the property's closure. With very few exceptions, every exchange that doesn't take place by these dates has all gains subject to taxation.

Speak with a Professional You Can Trust

Speaking with a trained professional is highly advised for anyone considering selling their real estate and buying a new property via a 1031 exchange. Many 1031 swaps have distinct looks. In addition to providing insight on the potential exchange, 1031 experts can lead investors to other 1031 exchange investment opportunities that might otherwise go unnoticed.

General Disclosure

Not an offer to buy, nor a solicitation to sell securities. Information herein is provided for information purposes only, and should not be relied upon to make an investment decision. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication.

1031 Risk Disclosure:

There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits

The Importance of a QI in Your 1031 Exchange

A qualified intermediary (QI) is required for all 1031 exchanges. Given the importance of the QI in an exchange, it is imperative for real estate investors to identify one they can trust and rely on. Achieving this, however, can be difficult – how does an investor know whether a particular QI is credible? Here is a brief tutorial on how to select a reputable QI for a 1031 exchange.

What is a QI?

A QI, also known as an accommodator, is an individual or entity that facilitates a 1031, or like-kind, exchange as outlined in Internal Revenue Code (IRC) Section 1031. The role of a QI is defined in the Federal Code as follows:

A qualified intermediary is a person who -

(A) Is not the taxpayer or a disqualified person, and

(B) Enters into a written agreement with the taxpayer (the “exchange agreement”) and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer. (26 CFR § 1.1031(k)-1)

An individual does not need to meet any eligibility requirements or acquire a license or certificate to become a QI. However, the Internal Revenue Service (IRS) does stipulate that anyone who is related to the exchanger or has had a financial relationship with the exchanger – such as an employee, an attorney, an accountant, an investment banker or broker, or a real estate agent or broker – within the two years prior to the sale of the relinquished property is disqualified from acting as the exchanger’s QI.

Why is having a QI important in a 1031 Exchange?

Every 1031 exchanger must identify a QI and enter into a written contract prior to closing on the relinquished property. Once selected, the QI has three primary responsibilities: prepare exchange documents, exchange the properties, and hold and release the exchange funds.

Preparing Exchange Documents

Throughout the exchange, the QI prepares and maintains all relevant documentation, including escrow instructions for all parties involved in the transaction.

New-York-City-real-estate-investing-Manhattan-skyline-retirement-planning-financial-services-Perch-Wealth

Exchanging Properties

A 1031 exchange requires the QI to acquire the relinquished property from the exchanger, transfer the relinquished property to the buyer, acquire the replacement property from the seller, and transfer the replacement property to the exchanger. Although the QI also transfers the title, the QI does not actually have to be part of the title chain.

Holding and Releasing Exchange Funds

For an exchanger to defer capital gains, all proceeds from the sale of the relinquished property must be held with the QI; any proceeds held by the exchanger are taxable. Therefore, the QI must take control of the proceeds from the sale of the relinquished property and place them in a separate account, where they are held until the purchase of the replacement property.

Exchangers must meet two key deadlines for the exchange to be valid. The first comes at the end of the identification period. Within 45 calendar days of the transfer of the relinquished property, the exchanger must identify the replacement property to be acquired. The second comes at the end of the exchange period. The exchanger must receive the replacement property within 180 calendar days of the transfer of the relinquished property. These deadlines are strict and cannot be extended even if the 45th or 180th day falls on a Saturday, Sunday, or legal holiday.

What should investors consider when choosing a QI?

Since a QI is not required to have a license, investors should conduct due diligence to ensure they select an individual who can properly manage the 1031 exchange. Unfortunately, the IRS does not excuse any errors committed by a QI, and, as a result, investors may be required to pay taxes on the exchange due to these mistakes. Here are a few things investors should consider when selecting a QI.

State Regulations

While the federal government does not regulate QIs, some states have enacted legislation that does. For example, California, Colorado, Connecticut, Idaho, Maine, Nevada, Oregon, Virginia, and Washington have all passed laws overseeing the industry. Many of these states have requirements for licensing and registration, separate escrow accounts, fidelity or surety bond amounts, and error-and-omission insurance policy amounts.

Federation of Exchange Accommodators

The Federation of Exchange Accommodators (FEA) is a national trade association that represents professionals who conduct like-kind exchanges under IRC Section1031. The FEA’s mission is to support, preserve, and advance 1031 exchanges and the QI industry. Association members are required to abide by the FEA’s Code of Ethics and Conduct.

In addition, the FEA offers a program that confers the designation of Certified Exchange Specialist® (CES) upon individuals who meet specific work-experience criteria and pass an examination on 1031 exchange laws and procedures. Holders of this certificate must pass the CES exam and meet continuing education requirements. The “designation demonstrates to taxpayers considering a 1031 exchange that the professional they have chosen possesses a certain level of experience and knowledge.”

Knowledge and Experience

As mentioned, a QI’s mistake in a 1031 exchange can result in a taxable transaction. Investors who are in the process of selecting an accommodator should review each individual’s qualifications – including knowledge and experience in the industry – before making a final decision. Investors should inquire whether the individual is full- or part-time; how many transactions and how much in value the individual has facilitated. Additionally, it is important to know whether the individual has any failed transactions and, if so, why.

Knowledge about 1031 exchanges is critical. Not only should potential QIs know the basics, but they should understand the ins and outs of the 1031 exchange process. For example, QIs should know what qualifies as a like-kind property. Likewise, they should know about Delaware Statutory Trusts (DSTs), one of the most commonly overlooked alternative 1031 exchange solutions. Unfortunately, many QIs are not familiar with DSTs. Finding a knowledgeable and experienced QI is crucial for investors who want to successfully defer capital gains while continuing to meet their overall financial objectives.

tax-deferrals-DSTs-1031-Exchanges-New-York-real-estate-qualified-intermediary-retirement-planning-future-savings-capital-gains

How should an investor go about selecting a QI?

To find a QI in good standing, investors should seek referrals. Word of mouth can be a great way to find a credible QI. Investors can ask for a referral from a certified public accountant (CPA) with 1031 exchange experience, a real estate attorney, a reputable title company, or even the other party in the exchange.

When vetting a potential QI, investors need to ask questions that will reveal the individual’s depth of knowledge and experience – beyond just the basics. For instance, the FAE requires potential QIs to work full-time for at least three years before they can even sit for the CES exam. Three years is a good baseline to start from when judging a QI’s experience; five to 10 years is a solid amount.

Finding a QI is one of the most critical parts of a 1031 exchange, as the transaction cannot be completed without one. Investors must ensure that their QI is experienced and thoroughly understands the various tax codes involved. Investors also need to ensure that the QI has not been financially connected to them within the past two years and is not a relative, employee, or agent. The IRS does not take these factors lightly; failure to comply with what is presented here may lead to hefty penalty fees – or the IRS may prohibit the exchange from occurring altogether.

General Disclosure

1031 Risk Disclosure:

There is no guarantee that any strategy will be successful or achieve investment objectives;
Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments;
Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
Potential for foreclosure – All financed real estate investments have potential for foreclosure;
Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits