Last updated on April 4th, 2020 at 11:14 am
Once you’ve learned about the incredible tax benefits of the 1031 exchange, investors start asking harder questions. Some of these questions include ones related to primary residence vs rental property in a 1031.
“Can I turn my property from a 1031 exchange into primary residence?”
“Can I benefit from both section 121 and section 1031 tax benefits on the sale?”
“Is there a length of time I must rent the property vs living in it?”
To be clear, this article will focus on whether you can re-purpose your newly acquired replacement property into a primary residence. The topic of whether you can turn a primary residence into a rental property, THEN do a 1031 exchange has been covered here.
We’ll talk through the basics, rules, and timelines for your 1031 exchange into a primary residence. After, we’ll walk through an example to demonstrate.
1031 Exchange Into Primary Residence – The Basics
Section 1031 of the IRC makes it very clear – your replacement property must be bought with the intent to use it as a rental or business property. For example, if you sell a $350,000 duplex and exchange it for a $350,000 single family home, you cannot make that home your primary residence for at least two years. Additionally, you must own the property for five years before selling in order to use section 121.
If you are in the clear based on the requirements above, you are likely asking “Am I able to defer all of the taxes when I sell the property?” While you can still benefit from section 121, unfortunately, the answer is no on section 1031 benefits.
Let’s look at an example:
Talia bought a $350,000 rental property as her replacement property during a 1031 exchange. In order to successfully complete the 1031, she rents it out for close to three years. This rental period ensures the IRS will view the property as “held for investment or for productive use in a trade or business.”
Just before the three year ownership mark, Talia moves into the property and makes it her primary residence. She lives there for over two years, which means it qualifies for section 121 benefits.
If Talia then sells the property for a gain in a 1031 exchange, will she owe any taxes? Unfortunately, the answer is YES. That said, it’s not as bad as selling the property outright, not using the 1031 exchange.
So what will Talia owe?
Depreciation, depreciation recapture amount, capital gains, basis, section 121 exclusion, are all considerations. These all depend on the carryover amount from the relinquished property.
Said another way, you won’t owe for taxes on this property, but you will owe for taxes on your last property. This is because your last property was exchanged for a replacement property. This property was partially held for investment or business and partially as a primary residence.
It is difficult to provide an estimate of the taxes Talia will owe. These vary wildly based on her personal situation, the basis in the property, and depreciation taken. There are scenarios where it makes sense to continue renting, and others where it’s wise to move in. This highlights the flexibility of the 1031 and 121 rules, and we advocate investors take full advantage. A 1031 exchange into primary residence can save thousands!
1031 Exchange Into Primary Residence – The Don’ts
Our example above is a great illustration of when the 1031 exchange into primary residence goes well. The IRS primarily cares about your “intent” when you first purchased the home. They’ll be on the lookout for things that ensure you first bought the home to be used as an investment, not as a primary residence.
The question becomes – “How can I prove that my intent was to use the home as an investment? And not just a 1031 exchange into primary residence?” From working with numerous qualified intermediaries, they said the following items below are classic signs that the “intent” was not honest.
- Don’t have plans or blueprints drawn up for your primary residence right before or after you do a 1031 exchange
- DO NOT move into the 1031 exchange property after acquiring it, even if temporary
- Don’t include in the contract to buy your replacement property a contingency that your primary residence needs to sell as well
- Don’t start construction on the 1031 exchange into primary residence property right after you buy it
- Document your efforts to rent out the house for at least a year before moving into it
The IRS does have a safe-harbor for determining that the 1031 exchange into primary residence was bought with the intent to use as an investment or business property. The property must have been owned for at least 24 months immediately after the 1031 exchange. In those first two years, the property must have been rented at a fair-market value, AND you can’t have lived in the property for more than 14 days each year.
If you have a section 1031 property that you’re thinking about moving into, we highly suggest contacting an accountant and a qualified intermediary. It can cause significant tax complexity, but done right can save your family enormous amounts of money. A 1031 exchange into primary residence is one of the top tax-savings available to everyday investors.