Discover How to Convert a 1031 Exchange into Your Primary Residence and Maximize Tax Savings
By Harlan Mayer, Principal Broker
Once you’ve uncovered the remarkable tax advantages of a 1031 exchange, investors naturally begin to delve deeper. This exploration often leads to questions regarding the distinction between a primary residence and a rental property in the context of a 1031 exchange.
“Is it possible to convert my property acquired through a 1031 exchange into my primary residence?” “Can I take advantage of both section 121 and section 1031 tax benefits when selling?” “Are there specific time requirements for renting the property versus living in it?”
Let me clarify that this article will specifically address the possibility of repurposing your newly acquired replacement property as your primary residence. The topic of converting a primary residence into a rental property and subsequently conducting a 1031 exchange has already been discussed elsewhere.
We will delve into the fundamentals, regulations, and timelines associated with executing a 1031 exchange into your primary residence. Additionally, we will provide an illustrative example to further enhance your understanding.
Getting Familiar with a 1031 Exchange into Your Primary Residence – The Basics
Section 1031 of the IRC leaves no room for ambiguity – your replacement property must be purchased with the intention of utilizing it as a rental or business property.
You must wait at least two years before making a $350,000 single family home your primary residence. In addition, you must own the property for five years before selling if you want to use section 121. If you meet the above requirements, you may be wondering if you can defer all the taxes when you sell the property. While section 121 can still be beneficial, unfortunately, section 1031 benefits are not available.
Let’s consider an example:
Samantha purchased a $350,000 rental property as part of a 1031 exchange. To successfully complete the exchange, she rented it out for nearly three years. This rental period ensures that the IRS sees the property as an investment or for business purposes.
Just before reaching the three-year ownership mark, Samantha moves into the property and makes it her main residence. She lives there for more than two years, making it eligible for section 121 benefits.
If Samantha then sells the property for a profit in a 1031 exchange, will she owe any taxes? Unfortunately, the answer is YES.
What will Samantha owe if she doesn’t use the 1031 exchange? Well, there are several factors to consider, such as depreciation, depreciation recapture amount, capital gains, basis, and the section 121 exclusion. All of these depend on the carryover amount from the property she relinquished.
To put it simply, Samantha won’t owe taxes on her current property, but she will owe taxes on her previous property. This is because her previous property was exchanged for a replacement property that was partly used for investment or business purposes and partly as a primary residence.
It’s difficult to give an exact estimate of the taxes Samantha will owe, as they vary greatly depending on her personal situation, the property’s basis, and the depreciation taken. There are situations where it might make sense for her to continue renting, while in others it would be wise for her to move in. This demonstrates the flexibility of the 1031 and 121 rules, and we encourage investors to take full advantage of them. A 1031 exchange into a primary residence can result in significant tax savings!
However, it’s important to note that our example above showcases a successful 1031 exchange into a primary residence. The IRS places a lot of importance on the “intent” behind the initial purchase of the home.
The house should be seen as an investment opportunity rather than a primary dwelling. The question then arises: “How can I demonstrate that my intention was to invest in the property, rather than just using a 1031 exchange to acquire a primary residence?” After consulting with various qualified intermediaries, they have identified several telltale signs that indicate a lack of honesty in one’s “intent.” These signs include: refraining from drawing up plans or blueprints for a primary residence shortly before or after completing a 1031 exchange, avoiding the temptation to move into the 1031 exchange property even temporarily, abstaining from including a contingency in the contract for the replacement property that requires the sale of one’s primary residence, refraining from commencing construction on the 1031 exchange property intended for use as a primary residence immediately after purchasing it, and documenting efforts to rent out the house for at least a year prior to moving in. It is worth noting that the IRS does offer a safe-harbor provision for determining whether a 1031 exchange property intended for use as a primary residence was indeed purchased with the intention of using it for investment or business purposes. This provision stipulates that the property must be owned for a minimum of 24 months immediately following the 1031 exchange.
If you have a property under section 1031 that you are considering residing in, it is strongly recommended that you seek advice from an accountant and a qualified intermediary. While it may bring about tax complications, if executed correctly, it can result in substantial savings for your family. The option to conduct a 1031 exchange into a primary residence is among the most beneficial tax-saving opportunities accessible to regular investors.
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