The Ultimate Guide to a 1031 Exchange Involving a Primary Residence

Last updated on June 23rd, 2021 at 02:39 pm

1031 exchange rules for a primary residence | Convert rental property to primary residence | Convert primary residence to rental property | FAQs 

Although a 1031 exchange primarily functions as a tool for investment properties, it’s also possible to use with a primary residence.

In fact, you can use a 1031 exchange in the process of:

  • Converting a rental property to a primary residence
  • Converting a primary residence into a rental property

Why would an investor want to do this? 

A 1031 exchange allows for the exchange of two investment properties while deferring your capital gains taxes. But the fact is, not all properties fit neatly into the category of “investment property” or “primary residence.”

You may have lived for a time in your investment property, or spent a year or two renting out your primary residence. In cases like these, you can use a 1031 exchange to defer at least some of your capital gains.

1031 exchange rules for a primary residence 

Just keep in mind:

  • Investors need to follow the rules of a regular 1031 exchange.
  • Investors need to follow the rules set forth in Internal Revenue Code (IRC) section 121, the part of the tax code that allows you to exempt capital gains on the sale of your primary residence.
What is IRC 121?
IRC 121 states: “[G]ross income does not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, the taxpayer has owned and used the property as the taxpayer’s principal residence for periods aggregating 2 years or more. ”

In plain English: You’re exempt from capital gains (up to $250,000 for single taxpayers, $500,000 for couples) on your primary residence as long as you’ve lived in it for two years out of the previous five.

So in order to take full advantage of IRC 121, the property involved in the 1031 exchange needs to have been used as a primary residence for at least two of the last five years, and as a rental/business property for at least the other three. 

This kind of transaction requires careful planning. One mistake and the exchange (and its tax deferral advantages) could be jeopardized. 

Contact us and we’ll put you in touch with our vetted 1031 exchange experts, so you can make sure your transaction doesn’t run afoul of the law.

Using a 1031 exchange to convert rental property to primary residence

So how exactly do you convert a rental property into your primary residence? And why would you want to?

First, the why. 

Let’s say you used a 1031 exchange to trade one investment property for another, deferring your capital gains taxes. 

After a few years of renting out this investment property you decide to move into it, using it as your primary residence. When you sell this property, you may wonder if you’re eligible to use IRC 121 to eliminate the capital gains you deferred when you upgraded to this property. 

The answer is yes — but only for the years you used the property as your primary residence. And only if you meet certain requirements. 

Example: 1031 exchange that converts a rental property to a primary residence

Lauren uses a 1031 exchange to secure a $350,000 rental property. 

Before she can convert this rental to a primary residence, Lauren must rent the property for at least two years to meet the 1031 exchange requirement that the property is “held for investment or for productive use in a trade or business.”

Separately, she needs to use the property as her primary residence for at least two out of five years to qualify for a 121 exclusion.

To meet these requirements, Lauren rents the property for three years and then lives there for two. After this five-year period, she sells for $450,000. 

Her capital gains on the sale — the difference in the amount she bought and sold the property for — is $100,000. The IRS assumes capital gains are accrued on a straight-line basis, so, at a 20% rate, that’s a flat $20,000 in capital gains in each of the five years.

Because Lauren used the property as her primary residence for two years, she can exempt her capital gains from those two years ($40,000) under IRC 121. The remaining $60,000, from the three years as a rental, are taxable as capital gains. At a 20% capital gains rate, she owes $12,000. 

On top of this, she’ll have to pay depreciation recapture on the three years the property was a rental. Laura uses our depreciation recapture calculator and finds she owes $9,544.50 in depreciation recapture. 

Her combined bill on capital gains tax plus depreciation recapture: $21,554.50.

Do’s and don’ts of converting rental property into a primary residence

If the IRS suspects you bought your property to be used as a primary residence instead of an investment, they may question the validity of your 1031 exchange — and the capital gains benefits you got from it.

To avoid this awkward situation, steer clear of behavior that might indicate to the IRS that you didn’t buy your property with the intent of using it as an investment. The keyword here is “intent,” as that’s what the IRS will be scrutinizing. To help your case, establish a healthy paper trail of your business activities before, during, and after your exchange.

✅ Do❌ Don’t
Document how you calculated the asking price for rent.Don’t have plans or blueprints drawn up for your primary residence right before or after the 1031 exchange.
Document the potential tenants who looked at your property. Record their names and their contact information.Don’t move into the new property right after the exchange, even if only temporarily or for a very short time.
Document the significant and reasonable amount you spent on marketing the rental property for a market-rate rent.Don't make the purchase of your replacement property contingent on the sale of your primary residence.
Document any change in circumstances (job loss, illness, divorce, etc.) that forced you to move into the investment property.Don’t start construction on the replacement property directly after the exchange.

Know the safe harbor for a 1031 exchange

The IRS does have a safe harbor for determining that your 1031 exchange replacement property-to-primary residence conversion was legitimate. This safe harbor states that:

  • The property has been owned for at least 24 months after the 1031 exchange.
  • During each 12-month period, the taxpayer must rent the replacement property at a fair market rate for 14 days or more.
  • During each 12-month period, the taxpayer’s private use of the replacement property must not exceed the greater of 14 days or 10% of the number of days during that 12-month period that the property was rented.
  • The property can be rented to a family member as a primary residence as long as market rent is paid.

If you fail to meet these conditions, your previous 1031 exchange could be rendered invalid.

Using a 1031 exchange to convert primary residence to rental property

Now let’s consider the opposite situation: converting your primary residence into a rental property. 

Why would a taxpayer want to? And how would they go about it?

First, the why. 

As touched on above, taxpayers are able to use IRC 121 to exclude capital gains from taxation — $250,000 for individuals and $500,000 for couples — if they’ve used a property as a primary residence for at least two of the five years before a sale. In some cases, the amount of capital gains they make exceeds those limits. 

In some of these situations, taxpayers can use IRC 121 to exclude their maximum amount of capital gains ($250,000 or $500,000) and then use a 1031 exchange to defer the rest. 

How do they go about converting a primary residence to a rental property? It’s pretty straightforward. Once they establish the property as their primary residence by living in it for two years, all they have to do is rent it out for two to three years before selling it — because, remember, they also have to meet the threshold of living in the property at least two out of five years before the sale threshold. 

Example: 1031 exchange that converts a primary residence to a rental property

Let’s say Bill and Julie, a married couple who file their taxes jointly, bought their home many years ago for $100,000. They’re now selling it for $1 million. 

They’re looking at $900,000 of capital gains — well over the $500,000 exclusion for couples. 

If they went ahead with a straight sale, they’d be able to exclude $500,000 of those gains under IRC 121, but they’d have to pay capital gains taxes on the remaining $400,000.

However, if they convert their primary residence to a rental, rent it for two years or more, and then sell through a 1031 exchange, their situation changes.

Let’s say they rent it for just under three years before they sell. Since they lived in the house as a primary residence for at least two of the previous five years, they’re able to exclude $500,000 in gains under IRC 121. 

But if they reinvest the remaining proceeds into an investment property through a 1031 exchange, they can defer the capital gains on the remaining $400,000.

Under the rules of the 1031 exchange, an investor has to acquire a replacement property with a market value equal to or greater than the relinquished property. However, in cases where some gain has been excluded under IRC 121, the amount of value the investor is required to reinvest in the replacement property is reduced by the amount of gain that was excluded under IRC 121.

For this example, that means that, even though Bill and Julie are selling a property for $1 million, they only have to acquire a replacement property worth $500,000, since they’re excluding $500,000 in gains through IRC 121.

Since you can repeatedly use 1031 exchanges to defer capital gains, and because you can use the IRC 121 capital gains exclusion once every two years, it’s possible to repeatedly convert your properties from an investment property to a primary residence, and vice versa, to defer or exclude capital gains.

What to avoid when converting a primary residence into rental property

Converting a primary residence into a rental property through a 1031 exchange is a little simpler than vice versa. Still, avoid these pitfalls:

  •  Don’t neglect to use the property as your primary residence for two out of the previous five years before the transaction to qualify for the IRC 121 exclusion. Even if you owned the property for 20 years, if you rent it for four years and then live in it for a year before selling it, you won’t meet the two-out-of-five rule.
  • Don’t forget that you can only use the IRC 121 exclusion once every two years.
  • Don’t overlook that if you’re using a 1031 exchange, the relinquished property and the replacement property, at the time of the exchange, must both be used for business or investment purposes.

Whether you’re converting a rental to a primary residence, or converting a primary residence to a rental, the nuts and bolts of doing a 1031 exchange can be confusing. Always consult with a qualified intermediary to make sure you’re following IRS guidelines. 

Contact us today for a free consultation with a seasoned vetted professional.

FAQs about 1031 exchanges involving a primary residence

Can I use a 1031 exchange on a multi-family property, where one unit is owner-occupied and the other units are rented out?

Yes. This is called a split-treatment transaction.

Basically, the sale is treated as separate transactions. The portion of the sale from the owner-occupied unit is handled under IRC 121, which grants a capital gains exclusion of up to $250,000 ($500,000 for couples) every two years.

The other portion of the sale is handled through a 1031 exchange, with the capital gains deferred as long as that portion of the sale proceeds is reinvested in a like-kind investment property.

How often can you use section 121 exclusion?

You can use a section 121 exclusion once every two years.

» READ MORE: What is IRC 121?

Can I move into my 1031 exchange property?

Yes — eventually. 

First, you have to use the property for investment/business purposes for at least two years to satisfy the conditions of the 1031 exchange. Also, here’s an overall minimum holding period of five years.

Once you’ve satisfied the first obligation, you can move into your 1031 exchange property. But for tax purposes, it won’t officially be a primary residence until you’ve lived there for at least two out of five years.

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