Holding Period

The confusion arises because section 1031 practice involves at least three separate clocks, and they measure different things over different periods for different purposes.

38.1 Tacking under section 1223

In determining the period for which the taxpayer has held property received in an exchange, there is included the period for which the taxpayer held the property exchanged, if two conditions are met.¹

The first condition is a substituted basis. The property received must have, for the purpose of determining gain or loss from a sale or exchange, the same basis in whole or in part in the taxpayer's hands as the property exchanged.

The phrase in whole or in part carries weight. A replacement property acquired partly with carryover basis and partly with new cash has a basis that is substituted in part, and that is sufficient. Excess basis does not defeat tacking, and the holding period of the property is not divided.

The second condition concerns the character of the relinquished property. The property exchanged must, at the time of the exchange, have been a capital asset as defined in section 1221 or property described in section 1231.

Both conditions are satisfied in the ordinary exchange without any planning. The basis of replacement property is substituted under section 1031(d), as Chapter 35 develops. Property held for investment is a capital asset, and real property used in a trade or business and held more than one year is section 1231 property. Property held primarily for sale is neither, but such property is excluded from section 1031 by the statute itself, so the condition is rarely the operative constraint.

The consequence is that the one year clock never restarts. A taxpayer who exchanges out of a building held fifteen years and closes on replacement property this morning holds long term property this afternoon. A sale of the replacement property the following week produces long term capital gain, not short term.

Three clocks, distinguished. The confusion this section exists to dispel is worth setting out directly.

The qualifying use requirement of section 1031 asks whether the property was held for productive use in a trade or business or for investment. It has no statutory period at all, and the frequently repeated one year or two year rules of thumb have no basis in the statute. Chapter 12 develops what the requirement actually asks.

The holding period of section 1223 asks how long the taxpayer is treated as having held the property for purposes of characterizing gain. It tacks, as this section describes.

The two year rule of section 1031(f) runs forward from the exchange and concerns subsequent dispositions between related persons. It is a limitation on what the taxpayer may do afterward, not a measure of what came before, and Chapter 40 develops it.

A fourth period appears where the property has been a principal residence, and its interaction with section 121 is taken up at Chapter 43.

38.2 Consequences for capital gain characterization

Because tacking is automatic in a qualifying exchange, the holding period rarely determines an outcome. What it does is deliver the taxpayer to the characterization rules with the long term box already checked, and those rules then do the work.

The section 1231 route. Real property used in a trade or business and held for more than one year is property used in the trade or business, excluding inventory and property held primarily for sale to customers.² Gain recognized on the sale or exchange of such property is section 1231 gain.³

Where section 1231 gains for the year exceed section 1231 losses, the gains and losses are treated as long term capital gains and losses. Where they do not exceed the losses, they are not treated as gains and losses from sales or exchanges of capital assets, which is to say they are ordinary.⁴

That asymmetry is the well known advantage of section 1231 property, and tacking under 38.1 assures that replacement property satisfies its more than one year requirement from the moment of acquisition.

The five year lookback qualifies the advantage and is regularly missed. Net section 1231 gain for any taxable year is treated as ordinary income to the extent it does not exceed the non-recaptured net section 1231 losses, which are the aggregate net section 1231 losses for the five most recent preceding taxable years reduced by amounts already recaptured.⁵

A taxpayer who took section 1231 losses in any of the preceding five years will therefore find recognized gain characterized as ordinary income before any capital rate applies, regardless of holding period and regardless of the exchange. The figure is knowable from the prior returns and belongs in the boot computation of Chapter 33 rather than in a surprise the following spring.

The rate composition. Assuming the gain survives as capital, it is not taxed at a single rate. Chapter 37 sets out the layers. Unrecaptured section 1250 gain is taxed at twenty five percent,⁶ and the remainder at the taxpayer's applicable rate on adjusted net capital gain.⁷ The net investment income tax and State income tax apply on their own terms.

The practical instruction that closes this chapter is a reallocation of attention. In advising on a proposed exchange, the holding period question will almost always answer itself in the taxpayer's favor and requires only confirmation that the relinquished property was a capital asset or section 1231 property. The questions that will actually change the client's decision are the composition of the rate on any recognized gain, the section 1231 lookback, and the depreciation consequences examined in Chapter 36.

Part VIII takes up the related party and anti-abuse regimes, beginning with the two year rule that constrains what the taxpayer may do with the replacement property after the exchange is complete.