2-Year Holding Period Rules for 1031 Exchanges Explained

A 1031 exchange allows you to sell one investment property and use the proceeds to buy a different one. You could use this method to diversify your portfolio, dip into a new market, or invest in a new location. But how long must you keep the property you purchase?

The so-called 1031 exchange 2-year rule applies here. 

While all of the contours of this rule aren’t clearly outlined in printed documents from the Internal Revenue Service (IRS), experts often coach their clients to hold onto their new properties for at least two years before selling or exchanging them. Doing so could help you to avoid excess scrutiny from the IRS. 

What Is a 1031 Exchange? 

A 1031 exchange is a dependent transaction involving two properties. Typically, you sell one property and purchase another with the proceeds. However, a reverse 1031 exchange is possible in which you buy a property, park it with a qualified intermediary, and sell another to complete the exchange. 

In a traditional real estate deal, investors are required to pay capital gains taxes on the profits from the property they sell. In a 1031 exchange, those taxes are deferred and rolled into the new property. 

The 1031 exchange process is designed to keep investors active within the real estate market. With these rules, investors are encouraged to keep buying and selling, so new opportunities arise for others to enter the market. 

What Properties Can Be Included in a 1031 Exchange? 

Per IRS rules, the two properties included within a 1031 exchange must be held in trade for business or investment. 

This rule means that the properties must be used as investments. In most cases, you can’t use things like primary homes or vacation homes in a 1031 exchange. Instead, you’ll buy and sell something like a grocery store, office park, or apartment building. 

However, these IRS guidelines also contain the basis for the 1031 exchange 2-year rule. The property you buy must be an investment property, and that means you can’t flip it or otherwise try to make a fast profit. If you sell the new property too quickly, the IRS might scrutinize the exchange and come after you for taxes. 

What Is a Holding Period? 

As most investors know, a holding period refers to the time between when you buy a property and when you sell it. If those two dates are very close together, you’re dealing with a short-term asset. If they’re far apart, you have a long-term asset. 

Commercial investors are often encouraged to use a holding period that is 5 to 10 years. This time frame allows the property value to rise, so you can sell it for a profit. However, there may be times when you should sell early. 

For example, you may need to divest because you’re dealing with a personal crisis and need fast cash. You may also need to sell early due to market downturns. Selling could allow you to diversify your portfolio and ensure you’re not taking unneeded risks. 

When you’re considering a sale, it’s important to consider the 1031 exchange 2-year rule. If you sell too early, you could face unintended financial consequences. 

What Is the 1031 Exchange 2-Year Rule? 

The 1031 exchange 2-year rule refers to the holding period for an investment. The rule can be explained in two different ways. 

Holding Rules Before You Sell to Strangers 

The 1031 exchange 2-year rule applies at the moment you want to sell your investment property to strangers. Your tax burden in a 1031 exchange isn’t forgiven, but it’s deferred. That means you’ll need to report your basis in the property on your tax documents every year. That paperwork can help the IRS understand how long you’ve owned the property.

If you choose to sell this property, you’ll report the sale to the IRS. If it’s been less than two years, it could trigger an audit. The IRS may believe that you didn’t intend to hold the property for an investment. Instead, auditors may believe you intended to flip the property for profit. 

Holding Rules Before You Sell to Relatives

The IRS is more specific about 1031 exchange properties sold to relatives. The rules state that you can’t transfer a property like this to a relative before two years have passed since the sale was completed. 

For example, you might find a perfect rental house and purchase it via a 1031 exchange. A few months later, your sister visits the rental and wants to buy it. Don’t complete that sale until at least two years have passed, or you’ll be in violation of the rule. 

Are These Rules or Guidelines? 

Documents from the IRS don’t contain all of the rules we’ve outlined here. However, that doesn’t mean you can sidestep this advice. 

Most investors use 1031 exchanges to avoid the steep tax penalties involved with selling a property. The more you own and the more valuable it is, the more you might get asked to pay. 

If you sell the property too quickly, those taxes you thought you avoided with an exchange could come due immediately. Depending on the audit, you might also be assessed penalties for late payments. 

If you’re hoping to build a real estate portfolio with 1031 exchanges, you may buy and sell properties often. Every time you trade, you roll that potential tax penalty forward. However, if you sell too quickly, you put all that at risk. 

How Can You Avoid a Penalty?

Whenever you use a 1031 exchange, you must keep pristine paperwork. These documents may help you if you’re in a tight spot. 

Keep documents such as the following:

• Rental agreements 

• Receipts for improvement expenses

• Payroll (if you hired someone to manage the facilities) 

• Canceled checks

• Bank statements 

All of this paperwork proves that you used the investments for commercial purposes only. You bought it to make money, and you used it for that purpose. 

If you must sell your property before the two-year period is up, those same documents could help you plead your case with the IRS. However, know that you may lose your case and be forced to pay. The safest way to avoid taxes is to ensure you don’t sell too quickly. Hold onto the property for the specified time frame to be in the best position when you sell.

Expert Help for 1031 Exchanges 

The 1031 exchange 2-year rule isn’t the only one you have to follow. In fact, typical 1031 exchanges involve plenty of rules and regulations. Missing even one of them could put all of your investments at risk. 

At 1031 Pros, we’ve helped investors just like you with these delicate transactions. Find out more about who we are and how we work. We’re ready to guide you through the process and answer any questions you have.

References

Like-Kind Exchanges Under IRC Section 1031. (February 2008). Internal Revenue Service. 

Real Estate Holding Periods: What You Need to Know. (October 2022). School of Commercial Real Estate Investing. 

26 U.S. Code 1031: Exchange of Real Property Held for Productive Use or Investment. Cornell Law School.