Sections 1031 and the 121 exclusion are music to most real estate investors’ ears. Not only are tax breaks available on rental properties through 1031, but everyday homeowners can benefit from 121 as well. It makes sense that investors will wonder things like:
“Can I combine section 1031 and 121, and benefit from both tax breaks?”
“Can I turn my primary residence into a rental, then 1031 it?”
“Is it worth turning my rental into a primary residence 1031 exchange, or the other way around?”
The answer is a resounding YES, and turning your primary residence into a rental can kick start anyone’s real estate investment portfolio. If you are not already familiar with section 121, here’s a refresher. It allows you to exempt capital gains on your primary residence. Up to $250,000 for single taxpayers and $500,000 for married taxpayers can be completely tax-free gains.
In this article, we’ll review the rules, timelines, and a couple of examples for your primary residence 1031 exchange. We’ll also talk about doing the same thing in reverse – turning a rental property into your primary residence.
Convert Primary Residence to Rental – Rules and Timelines
The rules for turning your primary residence into a rental, and making it eligible for both 1031 and 121 are fairly easy. Let’s say you’ve owned and lived in your home for two years. This two-year period makes you eligible for section 121 capital gains tax exemption.
After the two year period, you decide to move and start renting the property out. As long as you rent the property for three years, you will be eligible for the 1031. Also, you can still claim the capital gains exemption for the five-year time frame. This is assuming you sell before the five-year expiration period.
Your main tax hit will be on depreciation recapture from when the property was rented out. If it was rented for three years, and you took $10,000 in depreciation each year, you will owe $30,000*25% tax rate.
Converting Primary Residence 1031 Exchange to Rental – Example
Let’s say Lauren purchase a $350,000 single family home and lived in it with her family for two years. Then, they move and rented it out for three years. Just before five total years, they sell it for $484,050, which is a 6.7% annual increase in value.
What are Lauren’s capital gains, what does Lauren owe?
Lauren’s capital gains after the two year period is $48,471, but since she rented it out it gets tricky. If she had sold after two years she would not owe any of the $48,471 since it’s excluded by section 121.
After renting it out for three years, Lauren sold the property for $484,050, and claimed $38,182 in depreciation while it was a rental.
Her capital gains is $134,050 after the five years, and $38,182 of that is subject to depreciation recapture. The $134,050 is completely exempt from her taxes due to Section 121.
The depreciation recapture is still taxed, at the rate of 25%. This amounts to $9,545 and is the only tax Lauren owes. This is likely close to the amount of income tax she had saved from depreciation while it was a rental.
Net net, this technique saves you from paying capital gains on the large amount of profit you made on the property. Pretty good, eh? Now, let’s talk about how you can do this technique in reverse. By turning a rental into your primary residence, you can also benefit from both sections 1031 and 121.
Converting Rental to Primary Residence 1031 Exchange – Example
Let’s assume the same number from Lauren’s example (initial $350,000 purchase). Instead of living in the property, she decides to rent it out for the first three years. Then, she moved into it and used it as her primary residence for two years.
If Lauren sells for the same amount ($484,050), what does she owe in taxes? The answer is different than the previous example (turning primary into rental).
Her capital gains, the difference between what she sold the property for and what she paid for it, is still $134,050. The IRS requires you to assume that the amount of capital gains was accrued on a straight-line basis. Lauren owned the property five years, and $134,050 divided by five is $26,810.
Because Lauren lived in the property for two years, she is able to exempt those years from the capital gains amount, a total of $53,620. The rest ($80,430) is taxable as regular capital gains. Also, the depreciation recapture ($38,182) is taxed at regular income rates.
The total taxes due?: $9,545 on depreciation recapture as before, but also $12,065 on the capital gains from when the property was a rental. This adds up to $21,610, and is assuming you do not do a 1031 exchange on the property.
If you do want to do a 1031 exchange after all of these steps, there’s one thing to keep in mind. You must ensure that the property is in your name, or an LLC. This makes sure that you owned the property during the five years for section 121 qualification. Last, the most complex situation is when the original property was acquired as part of a 1031 exchange. We’ve covered that scenario here.
For any of these scenarios, we recommend working closely with your tax advisor. Before making a big change like moving into or out of a property for tax reasons, you should make sure you’ll reap the rewards that sections 1031 and 121 can provide.