How to Do a 1031 Exchange from a Rental Property to a Primary Residence
Even though the information on this web page is provided by a qualified industry expert, it should not be considered as legal, tax, financial or investment advice. Since every individual’s situation is unique, a qualified professional should be consulted before making financial decisions.
From this detailed guide you will learn how to use a 1031 exchange for replacing an investment rental property with a primary residence in a legal and safe way.
We will go over the IRS rules and methods to conduct the transaction in ways that comply with them. We will also cover benefiting the section 121 personal residence tax exemption additionally to avoiding paying the capital gains tax.
Note: if you are looking for a way to use a 1031 exchange for your current residence, read our guide How Can You Do a 1031 Exchange on a Primary Residence?. And you may also be interested in our other article Can I Do a 1031 Exchange on a Second or Vacation Home?. For more general information, read our guide 1031 Exchange Basics Explained with Examples.
Is It Allowed to Do a 1031 Exchange from a Rental Property to a Primary Residence?
You can do a 1031 exchange, then convert your rental property to a primary residence. However, you have to satisfy the 1031 requirements first. But why would you want to anyway?
This §1031 exchange allows you to defer capital gains taxes until the newly acquired (replacement) property is sold. Then, if that replacement property is converted (after two years) into your principal residence, you may escape some capital gains taxes permanently! It’s a win/win!
Major caveats: initially that acquired property can’t have been bought expressly for this very conversion purpose. Nor can it be immediately occupied as a primary residence. Yes, that’s federal taxation having its way with rationality. Then again, no rule says the newly acquired property must remain investment property forever.
There are lots of legitimate reasons for changing investment plans. Say your teleworking has become a big success with your boss. Now moving out of the city without fears of commuting nightmares is possible. You’re thinking about moving to a new primary residence with a backyard for your kids. If you can live with waiting periods, executing a §1031 exchange property may make sense.
How Can I Convert a 1031 Exchange Property into a Primary Residence?
If you are thinking about converting an investment property into a primary residence, there may be a way to save money in the process! What follows is complex (this is federal tax after all) so here’s a preview of what’s covered:
IRS §1031 Exchange from a Rental Property to a Primary Residence
- IRS 1031 like-kind property exchanges explained
a. Who qualifies
b. IRS safe harbor rules
c. Dos’ and don’t to qualify
d. Mechanics - IRS §121 primary residence capital gains tax exclusion
a. Special IRS rules involving §1031 exchanges
b. Exclusion limitations
c. Depreciation recapture tax not excluded - Full summary by example
a. Investment property purchase to §1031 exchange for primary residence
b. Post-exchange, primary residence sale under §121 - Wrap Up
1. IRS §1031 Like-Kind Property Exchanges Explained
a. Who Qualifies
Any tax payer who uses a property in their business or as an investment can take advantage of the 1031 exchange. In a typical IRS qualified §1031 like-kind property exchange, investors defer paying capital gains, depreciation recapture, and income taxes on commercial investment property when it’s sold.
Like-kind does not mean identical property, but it certainly excludes (with a twist) exchanges for primary residences. Typically, you must sell (relinquish) one rental property and buy another replacement as an investment.
Of course, the same tax payer must hold title to both properties. Only with mixed-use property–such as a triplex or ranch–might the rental portion of primary residence property be exchanged. This should be documented and discussed with your tax advisor.
Then there’s the exception for those with patience. There is no rule saying newly acquired property must be held as investment property forever. It’s possible to buy an investment property through a §1031 exchange, rent it out to tenants, and later use 1031 exchange property for personal residence.
After all, intentions may change later when you’ve collected rent at fair market value (FMV) for a significant period. Caution: the IRS may still require evidence that your original intent was for investment purposes. From the start, your claim to a change-of-mind can’t be an all-to-apparent sham, a veiled ploy to evade taxes.
So potentially you can turn a §1031 exchange investment property into a primary residence! Yes, but not right away. The acquired property must be held for a total of 5 years, with the first two being used as an investment. Consult your tax advisor/CPA for details.
b. IRS Safe Harbor Rules
IRS rules provide a safe harbor for determining how long a replacement property must be held as a rental before any conversion. Strict adherence to the following rules eliminates tax exposure regarding the exchange’s validity.
- You must own the replacement property for at least 24 months immediately following the exchange.
- For those 24 months, in each 12-month period you must:
- rent that property at fair market value (FMV) for 14 days or more
- limit using §1031 exchange property for personal residence to under 15 days or 10% of days during the 12-month period that the property is rented at FMV.
What if these safe harbor rules don’t apply? Then, it’s even more important for documented facts and circumstances supporting your investment intent on acquisition.
c. Dos’ and Don’ts to Qualify
Absent safe harbor cover, take good faith actions that could reasonably be expected of an investor. Conversely, avoid actions investors would be expected to shun. Some do’s that you should document–and don’ts–are listed here.
- Don’t make a quick move converting rental property into a primary residence after a 1031 exchange or take any preparatory action toward moving in soon. Wait at least 2 years.
- Demonstrate efforts to rent out the property at FMV with advertising, listings, other marketing.
- Be prepared to show how you arrived at the FMV.
- Confirm that no covenant or other impediment to rent out the property exists.
- Be prepared to show how an unforeseen event – lost job, illness, etc. – caused the change in intent.
- Don’t prematurely disclose any plans to move into the property.
d. Mechanics
Most often, these exchanges are delayed (delay between the sale and purchase closings), which requires sale proceeds be held by a Qualified Intermediary (QI) until reinvested in replacement property.
Two key timing rules must be observed in a delayed exchange. Once the sale of your property occurs, the Intermediary will receive the cash. Within 45 days of closing on the relinquished property, qualified replacement properties must be identified (ideally several should choices fail) and provided in writing to the QI.
Closing must then follow within 135 days (180 days total) for completion of the exchange. Failure to comply may void the exchange altogether.
Generally, this exchange keeps all your money invested rather than lost to taxes in the 20-30% range! There are exceptions. If all proceeds from the relinquished property aren’t reinvested, investors pay capital gains tax on the cash boot.
It’s taxed as partial sales proceeds – generally as a capital gain – from the sale of your property. If replacement properties have debt lower than those relinquished, investors pay capital gains tax on the so-called mortgage boot. That tax may be avoided by adding equivalent cash to the purchase price.
2. IRS §121 Primary Residence Capital Gains Tax Exclusion
a. Exclusion Limitations
When selling property as a primary residence, excluded capital gains (maximum of $250,000 for each single and $500,000 for married joint filers) may be attributed only to the time during which the property was used as your residence.
The maximum exclusion must be reduced by a ratio of time the primary residence had a non-qualified use (after the 2008 law change) to the taxpayer’s ownership time. This applies either to time preceding the home’s use as a primary residence or occurred between periods of use as a primary residence. More on this with the Summary to follow.
b. Special IRS Rules Involving §1031 Exchanges
Special IRS rules apply when selling these converted §1031 properties. Again, patience is required in step two when selling your principal residence.
There’s a holding period (five-years), which includes your time as owner of the property under §1031 and as your principal residence. It starts with the exchange date when the replacement property was acquired.
The five-year ownership and usage requirements need not be met within the same two years. Exceptions also apply to active military personnel required to relocate. Finally, the exclusion may only be used once every two years.
c. Depreciation Tax Is Not Excluded
The primary residence exclusion only applies to capital gains, not depreciation recapture. That tax is imposed on rental property depreciation that has previously been expensed. When that property is sold for more than its depreciated value, a recapture tax of up to 25% applies to that depreciation expense (no recapture on losses). More on this coming up.
3. Summary by Example
a. From the Initial Purchase of the Investment Property to §1031 Exchange for Eventual Primary Residence
Let’s say you owned an investment rental property bought in 2005 for $100,000. In 2009 using a §1031 exchange, that property was sold (relinquished) for $200,000 and a $300,000 condo (replacement) purchased. The $100,000 in capital gains is deferred plus any depreciation recapture.
b. Post-Exchange, Primary Residence Sale Under §121
It’s rented out for three years when in 2013 you move into the condo. In 2020 you sell the condo for $450,000 at a $150,000 gain. Adding the $100,000 previously deferred, total gains are $250,000 (Column 6 below).
Looking good–one would think–with that $250,000 §121 exclusion for singles. But wait! The IRS will allow only 73% of that gain ($182,500) to be excluded from the capital gains tax. It’s that ratio of property use by the taxpayer over total holding periods (Column 10). Per the chart below, $67,500 will be treated as taxable long-term capital gains.
Note the one-time anomaly to the taxpayer use rule: any holding prior to 2009 (4 years of investment non-use in Column 10) qualifies toward the exclusion. Those four years prior to 2009 plus the seven years you lived in the property are included for the capital gains exclusion as the numerator.
The Column 7 Excluded years include 2009 when taxpayer use first became a requirement for investment property, plus the three years your condo was rented out. Holding periods totaling 15 years (denominator) divided into the 11 qualifying years equals a 73% exclusion rate (Column 6).
Turning a 1031 exchange investment property into a primary residence
Depreciation recapture is another matter altogether. All depreciation deductions are taken on both properties while investments are taxable. Cumulative depreciation for tax purposes is ordinary taxable income upon the sale.
- Relinquished rental property: The IRS’ depreciation period is 39 years on commercial rental property. With a $100,000 tax basis, accumulated depreciation was $2,564 annually and equals $12,820 over the 5-year holding period. An approximate 25% of $3,200 recapture tax is imposed on accumulated depreciation.
- Acquired primary residence property: Again as 39-year property (define commercial vs residential) held 3 years as a rental, the 25% recapture tax applies its $300,000 tax basis. At $7,700 annually for 3 years, the 25% recapture rate applies to $23,000 or $5,775 in tax.
4. Wrap Up
You’ve deferred capital gains tax on $100,000 for over 10 years and then are taxed on $67,500 of $250,000 in total capital gains. The roughly $9,000 depreciation tax merely reflects recapture of tax savings from those years you claimed that expense.
Takeaways:
- Section 1031 exchanges are complex, requiring sophisticated planning and execution.
- Make good use of tax monies deferred in preparation for eventual reversals.
- Plan extended deferrals when possible if depreciation recapture is in check.
- No depreciation recapture taxes are imposed on sale losses.
- Be conscious of property use qualifications for the §121 and §1031 exclusions.
- Pre-2009 investment property has the biggest savings, $20,000+ more on the chart.
- Without needed expertise or extensive time to devote, professional help is imperative.
As you have already understood from the article, there are many crucial intricacies included in a 1031 exchange, especially, when a primary residence is involved. The good news is that a Qualified Intermediary (that will certainly be involved in the transaction, as required by IRS) will help you take care of all 1031 exchange-specific details to keep everything perfectly acceptable by the IRS.
Not only will a good QI conduct the transaction itself, but they will also consult you and your tax advisor/CPA on the necessary preventive measures to take before and after it, so that the fact that a residence is involved in a 1031 exchange will not be considered as a fraud.
As a national all-in-one platform for real estate investors, we maintain relationships with the best 1031 exchange companies in all of the U.S. states and Washington D.C. If you want to be connected with a top-rated professional in your location, fill out the form below.