When Does the 2-Year Holding Rule Apply in 1031 Exchanges?

In a typical, arm’s length #1031 exchange, the parties to the process only come together because one is selling something the other one wants. They don’t likely know each other, and, in many cases, may never meet at all. For those transactions, the two-year holding rule never comes into play.

However, when related parties want to use section 1031 to exchange property, this nuanced rule is applicable. Both sides must be clear on this part of IRS code. When related parties exchange property and want to qualify for tax-deferred treatment under section 1031, special rules apply to the transaction. These special rules were implemented by the IRS to try and curb basis shifting abuse between related parties. One of the most important of these rules is the Two-Year Holding Period requirement.

This rule requires that, when related taxpayers exchange property with each other, the property must be held for at least two years following the exchange to qualify for non-recognition treatment for both parties. If either party disposes of the property they received under the 1031 exchange prior to the expiration of the two-year period, any gain or loss that would have been recognized on the original transaction must be recognized in the year the disqualifying disposition occurs.

But what happens when only part of a 1031 exchange transaction involves related parties? Perhaps one taxpayer wants to relinquish property to an unrelated party but receive property from a related party, or vice versa. Like most things involving the IRS, the rules get a bit more muddled.

When a taxpayer sells to an unrelated party but receives replacement property from a related party, the transaction will not qualify under section 1031 if the taxpayer receives any cash in the transaction. If no cash is received, then the transaction should be ok.

However, whether the replacement property must be held for two years is unclear. While Form 8824 implies that the two-year rule applies, several Private Letter Rulings issued by the IRS say that the two-year rule does not apply to the related party who purchases the relinquished property.

If a 1031 exchange is in your future, visit our website to learn more about these powerful tax deferral tools and our qualified intermediary and replacement property locator services.