The 1031 Exchange is perhaps the most used tax strategy for experienced real estate investors. This tax-deferred strategy allows investors to sell an investment or business property and replace it with a like-kind real estate property. The benefit of the 1031 exchange is that investors can defer capital gain tax from property sales. The IRS has set specific regulations for real estate investors to avoid disqualification from the 1031 Exchange. Apart from the 45-day and 180-day rules, there is a 2-year rule of the 1031 Exchange. The article focuses on understanding the 2-year rule for tax-deferred exchanges.

Understanding the 2-Year Rule of the 103 Exchange

The IRS mandates that all real estate properties in the like-kind exchange undergo a 2-year holding period to become eligible for the use test. Although there is no specific rule on this, tax and IRS advisors consider the 2-year safe holding period for real estate properties acquired through the 1031 Exchanges.

The 2-year rule holding period intends to utilize the real estate as an investment. Further, the intention is expressed on several tax returns. The property generates consistent rental income during the period. If the investors plan to utilize the property as a personal home, they should ensure it fits the rules and regulations of the IRS. Some tax advisors recommend a minimum of 1-year holding period. For 1031 Exchanges, the 2-year holding period is mandatory.

For instance, if investors acquire rental properties in the 1031 Exchange, it is ideal to hold for two years, generating rental income and filing it on two tax returns before conducting another property exchange.

Property Held for Less than 2 Years: Recently Acquired Property

Properties held for less than two years are recently acquired and are not eligible for tax-free exchange. Section 1031 (f) of the IRS (Internal Revenue Code) states that investors should hold an exchanged property with an associate for two years, lest the exchange become unqualified.

For instance, if investors execute a 1031 exchange with siblings or family members, they should hold it for at least two years. If investors try to bypass the rule, it becomes complex, and the 1031 Exchange disqualifies.

Property Held for Less than 2 Years is Taxable

No concrete regulation or rule states that a business or investment property should be on a 2-year holding period before considering the 1031 Exchange. The reasons are:

• When the property is held for two years, it is reflected in two yearly tax returns. It shows the intent to use the property for investment.
• The tax code is not compulsory for a one-year hold, but the IRS prefers long-term gains beginning after one year.

For example, investors purchase properties with the motive to hold them but sell before two years in the 1031 Exchange. There must be a clear set of rules, and real estate investors encounter strict scrutiny from the IRS. The safe practice is to hold the business or investment property for two years in the 1031 exchange.

Exceptions for Not Complying with a 2-Year Holding Period

The IRS (Internal Revenue System) has the authority to allow exceptions to the 2-year holding period in certain exceptions.

• In private letter regulations, a minimum holding period of 2 years is sufficient. However, these regulations don’t guarantee the legal rights of all investors.
• Some tax experts recommend that a 1-year holding period reflects the property investment in two annual tax filing reports. The perception needs to be present in the tax codes.
• The Internal Revenue System practices a 1-year-and-1-day policy or rule to audit exchanges, guaranteeing no biases across taxpayers.

They are general exceptions, and the IRS assesses 1031 Exchanges differently on a case-by-case basis. The investment motive or intent matters the most for a successful 1031 Exchange.

Conclusion

It is not mandatory by the tax code for investors to hold properties for a specific time frame before qualifying for the 1031 Exchange. The Internal Revenue System applies the rule to understand the motive or intent of the investors entering the 1031 exchange. One of the benefits of the 2-year holding period is that the rule eliminates fraudulent property exchanges and guarantees legitimacy in the process. Further, the holding period rules prevent investors from flipping investment properties and seeking a break from long-term capital gains tax.