In order for property to qualify for a Like-Kind Exchange, both the relinquished property sold and the replacement property acquired must meet certain requirements. One fundamental requirement is that both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, or property that is held for sale in a business does not qualify for like-kind exchange treatment. At times, a taxpayer may wish to convert business property to personal use or may have an opportunity to sell the property soon after its acquisition as either relinquished or replacement property. We are often asked what the IRS considers an adequate "holding" period in such instances. An initial response would be that the IRS only sets out two explicit holding periods.

Under § 1031(f)(1), the non-recognition provisions of § 1031(a) do not apply to an exchange between related parties if either of the parties sells the exchanged property within 2 years of the exchange. In October 2004, Congress passed the American Jobs Creation Act, of which Section 840 effectively closed a loophole that previously allowed taxpayers to take advantage of the absence of guidelines. The Act amended Section 121(d) (relating to special rules for exclusion of gain from sale of principal residence) by adding at the end the following new paragraph:

(10) Property Acquired in Like-Kind Exchange – If a taxpayer acquired property in an exchange to which section 1031 applied, subsection (a) shall not apply to the sale or exchange of such property if it occurs during the 5-year period beginning with the date of the acquisition of such property.

It is to be expected that when the question arises, taxpayers desire a decisive answer and advisors often seize upon the 2-year period specified for related parties to satisfy that desire. In such cases one would suppose that a 12-year holding period would certainly be considered long enough for property to be considered to be "held for investment." However, as shown in Allen v. U.S. 113 aff'd2. d 2014-2262 (2014), the intent of the taxpayer controls the characterization rather than the length of the holding period.  In Allen, the taxpayer admitted that he originally acquired the property to develop it and resell it.  However, when the IRS denied Capital Gains treatment, he argued that he changed his mind and decided not to develop the property and subsequently continued to hold it "for investment" until he could sell it. 

This case illustrates that the intent of a taxpayer of whether to hold property for resale or to hold for investment, is a critical issue as to its characterization when capital gains treatment or a qualified like kind exchange tax deferral is challenged by the IRS.  As taxpayers typically do not document their thinking, proving a question or fact such as the taxpayer's intent may prove difficult.   Courts take into account a number of factors to determine if property was held for sale or for investment. The Tax court here, citing Pool v. Commissioner, 251 F.2d 233, 236 [1 AFTR 2d 428] (9th Cir. 1957) (quoting Rollingwood Corp. v. Commissioner, 190 F.2d 263, 266 [40 AFTR 1006] (9th Cir. 1951)) lists several factors that a court should consider in determining whether property was held by a taxpayer primarily for investment or for sale to customers in the ordinary course of the taxpayer's trade or business, including:

(1) the nature of the acquisition of the property;

(2) the frequency and continuity of sales over an extended period;

(3) the nature and the extent of the taxpayer's business;

(4) the activity of the seller with respect to the property; and

(5) the extent and substantiality of the transactions.

The opinion citing appropriate authority notes that each case is decided upon its particular facts, that the presence of any one or more of these factors can determine the outcome of a particular case and that the taxpayer bears the burden of proving that the IRS's determination is wrong. Importantly, in considering the first of the listed factors, the tax court quoting Pool observes: ""[w]hile the purpose for which the property was acquired is of some weight the ultimate question is the purpose for which the property is held."" In Allen, the court found that the taxpayer failed to adequately prove that he changed his intent to "holding the property for investment."  In deciding the case in favor of the IRS, the Tax Court found the following evidence persuasive:

• Over a period of years, the taxpayer attempted to develop the property on his own;
• He then brought in partners who contributed capital for development;
• He subsequently sold the property to a developer;
• After making significant and extensive efforts to develop the property over many years, he failed to show his change in intent by his changed actions with regard to the property;
• That he failed to provide any evidence to prove that his intent changed.

The Court citing Tibbals v. United States, 362 F.2d 266, 273 (1966), acknowledged that the taxpayer's intent with respect to a property can change over time and that the intent during the period prior to the sale is the critical. It determined that the taxpayer failed to furnish any evidence that adequately demonstrated when, how, or why his intent changed.

The Allen case demonstrates the need to preserve solid evidence that documents and clearly establishes proof of a taxpayer's assertions that their intent with regard to an exchange property changed from an intent to sell property to an intent to hold for investment. While a short holding period might cause an adverse characterization by the IRS with regard to the taxpayer's intent, this case clearly demonstrates that the opposite is not implied by a lengthy holding period.