The 1031 Exchange Qualified Use Requirement and Importance of Intent - Is Time a Factor?

Property must be held (i.e. owned) for investment or business use by a taxpayer effectuating a 1031 tax-deferred exchange – this is known as the “qualified use” requirement. This rule applies to the property being sold to start the exchange, as well as the property acquired as replacement property in the exchange. The taxpayer, in order to meet this qualified use requirement, must be able to show the requisite level of intent. What role, if any, does the length of the time the property is held by the taxpayer play? Though the Internal Revenue Code and Treasury Regulations are silent on this issue, a careful analysis of some relevant IRS rulings and case law yields some principles that may serve as a starting point for a conversation with your independent tax advisor or counsel.


It should be noted that the IRS has issued certain rulings stating that if the property a taxpayer seeks to exchange was acquired immediately before the attempted exchange, the taxpayer will be viewed as having acquired that property primarily to resell for profit, not for investment or business use (see Revenue Rulings 84-121, 77-337, and 57-244). The IRS has also taken the position that if replacement property is disposed of immediately after the exchange, the property cannot be viewed as being held for a qualified use (see Revenue Ruling 75-292). However, the courts have been more taxpayer-friendly when evaluating whether the time held affects the taxpayer’s intent to hold the property for investment or business use (see 124 Front Street Inc. v. Commissioner, 65 T.C. 6, 1975). Yet in certain cases, the courts have agreed with the IRS’s position on disqualifying an exchange when the replacement property is disposed of soon after its acquisition via exchange (see Black v. C.I.R. 35 T.C. 90, 1960). 


Taking the above into consideration, the IRS has not explicitly stated whether there is a definitive requirement or safe harbor ownership period that will prove the requisite intent to hold property for investment or business use, satisfying the qualified use requirement. The question thus becomes, to what degree might time be a factor in showing the appropriate level of intent?

Some tax advisors look to Private Letter Ruling (“PLR”) 8429039 (1984) as a guidepost, in which the IRS stated that a holding period of two years would be a "sufficient" period of time for the property to be considered held for investment. However, private letter rulings do not constitute binding precedent. There is also a Revenue Procedure (2008-16) that suggests a two-year safe harbor to meet the qualified use test, but specifically in the context of property being used for personal vacation use in addition to investment purposes. 

There are other general tax principles, unrelated to 1031 exchanges, that lead some tax advisors to suggest property be held for at least one calendar year. The holding period for long-term capital gain treatment is over a year of ownership, which is one possible place this idea stems from. Additionally, in 1989, through HR 3150, Congress had proposed that both the relinquished and replacement properties be held for one year to qualify for tax-deferred treatment. Though this timeline was just a proposal, and it was never incorporated into the tax code, some tax advisors nevertheless believe that it represents a reasonable minimum guideline. Others, by contrast, believe the lack of adoption of a time requirement to satisfy the qualified use requirement shows the lack of desire by Congress to make such a requirement necessary.


The differing opinions of the IRS, the courts and the legislature reveal that the determination of whether a property is held for a qualified use will be made on a case-by-case basis, taking into consideration all of the facts and circumstances that apply to the taxpayer's particular situation. If audited, the taxpayer will have the burden of proving that their "intent" when purchasing the replacement property, or when they acquired the relinquished property, was to hold the property for investment or for business use, regardless of the amount of time it was held. Note that a taxpayer's purpose for ownership can change while they hold the property (see Reesink v. Commissioner, TC Memo 2012-118). In general, the longer a taxpayer owns property, the easier it may be to prove investment intent, but Courts have approved of exchanges when the relinquished property was held for only five days (see Allegheny County Auto Mart v. C.I.R. 208 F2d 693, 1953) and when the replacement property was converted to personal use after only eight months (see Reesink, supra). 

The courts have also been positive towards taxpayers in cases where an exchange occurring after a partnership or corporate distribution, or prior to contributing the replacement property to an entity, results in the taxpayer effectively owning the same investment (through a different form of ownership). These transactions have not posed an impediment to meeting the qualified use requirement in several cases, for reasons such as there being no intent to liquidate an investment for personal purposes, or because there was the same economic interest held in the real estate by the taxpayer with the same level of control. (See, e.g., Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985) and Maloney v. Commissioner, 93 T.C. 89 (1989)). 


Though IRS and court rulings will differ in each transaction depending upon the specific circumstances, a taxpayer can increase their chances of surviving an IRS audit if the intent to complete a 1031 tax-deferred exchange is documented as soon as possible. Exchangors should work with their real estate agent and tax advisor to help create a paper trail documenting their intent to ensure a successful exchange.


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