How Can You Do a 1031 Exchange on 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.
In this detailed guide we will discuss legal ways to use a 1031 exchange for your primary residence, whether you want to acquire another primary residence or a rental home as a replacement property.
We will also cover taking advantage of the Section 121 allowing tax exemption when selling a residence so that you can benefit from it additionally to the 1031 tax deferral.
Note: we also have an extensive guide explaining all basics of how 1031 exchange works and its rules in general.
How Can You Use a 1031 Exchange for a Primary Residence?
Yes, you and your spouse, if you have one, can do an exchange on personal residence, by converting your primary residence into a rental property. And then, as we explained in our other guide in more detail, you can convert the acquired rental property to another personal residence.
But why would you want to make this exchange anyway? One reason is a home sale gain exceeding the §121 $250,000/$500,000 home sale gain exclusion. Especially if it’s a big, big gain.
Or trending rental rates are much higher than your current mortgage and home insurance payments. Might it be a good time to convert and buy a new home? Already you’ll likely qualify for larger loans with new lease(s) offset your mortgage. Speaking of buying, want to avoid that new home purchase clause? That one which stipulates your old home must sell first.
The strategy is for homeowners to arrange property exchanges meeting requirements for the §121 primary residence exclusion and tax deferral under §1031. But what about §1031 exchange requirements that both properties be held as investments? IRS rules provide exceptions, quite complex ones, so first here’s a preview of what’s covered next.
- Combining §121 primary residence exclusions with §1031 tax deferrals
a. Who qualifies
b. Dos’ and don’t to qualify
- Full summary by example
a. Investment property purchase to §1031 exchange on personal residence
b. Post-exchange, primary residence sale under §121
- Risk assessment
- Wrap Up
Note: you may also be interested in our article Can I Do a 1031 Exchange on a Second or Vacation Home?
1. Combining §121 Primary Residence Exclusions with §1031 tax Deferrals
a. Who Qualifies
Section 121 states that a personal residence can be exempt from capital gains tax through a §1031 exchange if an investor has both owned the property for at least five years and lived in it for two out of those five years. Conversely, your primary residence must have served as a rental property for about two years before you decide to sell it.
So if within the prescribed time frames, you have resided in and rented your primary residence, the §1031 exchange will qualify. During this rental period, you may not occupy it in any fashion. Rather you should retain evidence of residency elsewhere. Now rented out to tenants at FMV (Fair Market Value), you may make a §1031 exchange.
b. Dos and Don’ts to Qualify
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.
- Confirm no covenant or other impediment to rent out the property exists.
- Demonstrate efforts to rent out the property at FMV with advertising, listings, any other marketing tools.
- Be prepared to show how you arrived at the FMV.
- Don’t prematurely disclose any plans to move into the property.
- Don’t make quick moves converting rental property into a primary residence.
- Be able to show an unforeseen event – lost job, e.g. – caused intent to change.
This exchange is even more complex than exchanging an investment property to a primary residence. In most instances, professional help from a tax advisor/CPA is advisable. Again, most often it’s a delayed exchange (delay between the sale and purchase closings). Sale proceeds are held by a Qualified Intermediary (QI) until reinvested in replacement property.
The same two key timing rules apply. Within 45 days of closing on the relinquished property, qualified replacement properties must be identified and provided in writing to the QI. Closings on all replacement properties must then follow within 135 days (180 days total) for completion of the exchange. Failure to comply may void the exchange altogether.
IRS rules following §1031 like-kind exchange rules will apply.
- Replacement property basis is decreased by gains deferred under §121 exclusions.
- Any cash boot received is subtracted from the replacement property basis.
- Boot (cash or property besides acquired property) is not taxable unless it exceeds the gain excluded under §121 rules.
- If a replacement property’s debt is lower than the relinquished one, capital gains tax applies on what is called mortgage boot. It may be avoided with equivalent cash added to the purchase price.
2. Full Summary by Example
Say you and your spouse owned a home with a $500,000 tax basis for many years. In 2013, it’s worth $2.5M! No wonder you’re looking to defer capital gains taxes. Since the §121 primary residence exclusion won’t cover the capital gains, you go for a §1031 like-kind exchange deferring those gains and any recapture depreciation, as well.
First renting out for two years to satisfy investment property rules. Then in 2015 it was exchanged for a triplex apartment building worth $2M plus $500,000 of cash boot to match your home’s evaluation.
Because the $500,000 cash boot did not exceed the $500,000 §121 excluded gain, it’s not taxable for federal income tax purposes. Capital gains taxes are deferred on the $1.5M that exceeds the tax basis and §121 excluded gain. Depreciation recapture is also deferred.
Eventually there’s no escaping the gains deferral short of death literally. Then due to basis step-up, the property’s current FMV becomes the new tax basis. Your heirs would owe tax only on any property appreciation going forward.
3. Risk Assessment
A basic issue up front: how suitable are properties as rentals in the first place? Regarding your primary residence, something to consider at the outset. You’ll want to keep that in mind when searching for replacement property.
Before and after the exchange, you cannot occupy either property for around two years. Remember the §1031 exchange must involve investment properties, not your primary residence. That may mean two mortgage payments, property tax bills, and two insurance policies. Then too, you now have maintenance and repairs issues on two properties.
Speaking of maintenance, extra funds will be needed to cover these expenses. No surprise: expect lenders to be cautious. Lender rules may dictate that borrowers have some funds set aside for contingencies. The prior minimum of 30% equity requirement is gone. It’s replaced with the usual credit and income requirements.
On the plus side, under Fannie Mae guidelines, any new lease agreement qualifies as income toward credit worthiness. However, if the relinquished property was a single unit home (as in this example) only 75% of that lease is allowed on your current home.
4. Wrap Up
Combining the home sale gain exclusion with a tax-deferred §1031 exchange could significantly defer taxes. This is especially true when selling a highly appreciated principal residence, one exceeding the §121 gains exclusion.
It can’t be done overnight. To qualify for the §121 home sale gain exclusion, a property must have been used as the taxpayer’s principal residence for at least two years during the five-year period ending on the exchange date. To qualify for tax-deferred §1031 exchange, both relinquished and replacement property must be rentals for a recommended two year period.
The more tax your §1031 defers or escapes, assume IRS audit chances increase, as well. That two-year safe-harbor rule does provide some shelter from any IRS challenge. Nonetheless, it’s likely you’ll need professional assistance to ensure things get done right.
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 details to keep everything perfectly legal.
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.
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