Convert investment to primary

Member since 2018 · 14 posts · 1 vote

Hello,

We sold our primary residence mid 2024 and moved into our investment property that we acquired in 2020. The investment property was purchased through a 1031 exchange. I would like to get clarification as to whether we can sell our now primary residence without having to pay capital gains. And if we had to pay what amount or percentage would that be? We will have stayed there 2 years this coming June.

Some background information:

Primary residence purchased in 2018 for $1mil - Sold 06/2024 for $1.4mil. No taxes paid as under $500k cap.

Investment property purchased in 2020 via 1031 (relinquished property bought for $140k and sold for $330k)

Replacement bought for $750k + $100k remodel throughout

Moved into investment property 06/2024 until present.

As always, your expertise is much appreciated.

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E.J. McCaffrey

Member since 2025 · 194 posts · 140 votes

Since the property was originally purchased through a 1031 exchange, to be eligible for the Section 121 exclusion, you must have owned and lived in the property for at least two out of the last five years as your primary residence. Since you moved in around mid-2023, you will have met the two-year residency requirement by mid-2025. Additionally, the IRS has a five-year ownership rule for properties acquired through a 1031 exchange, meaning you must own the property for at least five years before you can take advantage of the capital gains exclusion. Since you bought the property in 2020, you will meet this requirement sometime in 2025, depending on the exact purchase date. Therefore, if you wait until the five yearmark before selling, you should qualify for the Section 121 exclusion.

Note: This information is for educational and informational purposes only and does not constitute legal, tax, or financial advice. No attorney-client, fiduciary, or professional relationship is established through this communication.

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Clayton Silva
Lender · CA · Member since 2018 · 637 posts · 393 votes
1y
As I understand it (please consult/confirm with a CPA) this is not tax or legal advice.
Pretty sure you met 1 of 2 criteria.
1) When you 1031 INTO a new property, you CANNOT live in it for at least 2 years. It has to be a rental for 2 years before it can be converted to a primary. Check (2020-2024 investment) so you are good there.
2) To get the benefit of 250k in cap gains tax free (500k if married), you have to have lived in said property for another 2 out of the last 5 years. Not check, (according to your post you will hit this in 06/2026). So that is the part you will want to confirm with your CPA if I am understanding your timeline and question correctly.
Hope this helps!
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Kimi Ho
OP
Member since 2018 · 14 posts · 1 vote
1y
Hi Clayton,
Thanks for the response. We actually sold and moved in 2023. I got slightly confused there. So it seems we are hitting the 2 year milestone this Summer. Per your advice I will consult with my accountant. Thanks again.
0 Reply
- Clayton Silva
  Lender · CA · Member since 2018 · 637 posts · 393 votes
  1y
  Quote from @Kimi Ho:
  
  Hi Clayton,
  Thanks for the response. We actually sold and moved in 2023. I got slightly confused there. So it seems we are hitting the 2 year milestone this Summer. Per your advice I will consult with my accountant. Thanks again.
  
  Stellar! Best of luck and super smart strategy!
  0 Reply
E.J. McCaffrey
Member since 2025 · 194 posts · 140 votes
1y
Since the property was originally purchased through a 1031 exchange, to be eligible for the Section 121 exclusion, you must have owned and lived in the property for at least two out of the last five years as your primary residence. Since you moved in around mid-2023, you will have met the two-year residency requirement by mid-2025. Additionally, the IRS has a five-year ownership rule for properties acquired through a 1031 exchange, meaning you must own the property for at least five years before you can take advantage of the capital gains exclusion. Since you bought the property in 2020, you will meet this requirement sometime in 2025, depending on the exact purchase date. Therefore, if you wait until the five yearmark before selling, you should qualify for the Section 121 exclusion.

Note: This information is for educational and informational purposes only and does not constitute legal, tax, or financial advice. No attorney-client, fiduciary, or professional relationship is established through this communication.

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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
1y
@Kimi Ho Converting the 1031 exchange property to your primary residence and then later selling can be a great strategy to eliminate some of the deferred tax.

If the property you have converted into your primary was a product of a 1031 exchange you must first of all have owned it for 5 years before you can sell and take the partial sec 121 exemption.

Secondly, you will prorate the gain according to the number of years you lived in the property, which is called "qualified use" versus the number of years it was a rental, which is "nonqualified use." Only part of the gain will be tax-free some will always be taxable. The qualified use time will be tax-free up to the limits of sec 121. The non-qualified use time you will pay tax on.

It looks like you roughly fit those criteria almost perfectly - You've owned it for 5 years. You used it for rental for 3 years and have lived in it for 2 years. You would get 2/5ths of the gain or 40% tax-free. You would pay tax on 60% of the gain. And you would have to recapture depreciation. If you stay there one more and you would get 3/6ths of the gain tax-free. Stay there one more year and you would get 4/7ths of the gain tax-free etc etc...

You'll never get it all tax free. But a big chunk can be!!!
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- Clayton Silva
  Lender · CA · Member since 2018 · 637 posts · 393 votes
  1y
  Quote from @Dave Foster:
  
  @Kimi Ho Converting the 1031 exchange property to your primary residence and then later selling can be a great strategy to eliminate some of the deferred tax.
  
  If the property you have converted into your primary was a product of a 1031 exchange you must first of all have owned it for 5 years before you can sell and take the partial sec 121 exemption.
  
  Secondly, you will prorate the gain according to the number of years you lived in the property, which is called "qualified use" versus the number of years it was a rental, which is "nonqualified use." Only part of the gain will be tax-free some will always be taxable. The qualified use time will be tax-free up to the limits of sec 121. The non-qualified use time you will pay tax on.
  
  It looks like you roughly fit those criteria almost perfectly - You've owned it for 5 years. You used it for rental for 3 years and have lived in it for 2 years. You would get 2/5ths of the gain or 40% tax-free. You would pay tax on 60% of the gain. And you would have to recapture depreciation. If you stay there one more and you would get 3/6ths of the gain tax-free. Stay there one more year and you would get 4/7ths of the gain tax-free etc etc...
  
  You'll never get it all tax free. But a big chunk can be!!!
  Huh, this is super interesting! This might be the first time I have heard this.
  1 Reply
Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
1y
@Clayton Silva, It is a great opportunity in the right situations. We have clients selling their primary residences and taking that money tax free. And then moving into their former investment properties quite often. That starts to turn tax deferred into tax free!!! For many it's been a banger of a retirement plan. Thanks to the Tax Cuts and Jobs Act of 2017!!
The 1031 Investor5137 Reviews
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2 Reply
- Clayton Silva
  Lender · CA · Member since 2018 · 637 posts · 393 votes
  1y
  Quote from @Dave Foster:
  
  @Clayton Silva, It is a great opportunity in the right situations. We have clients selling their primary residences and taking that money tax free. And then moving into their former investment properties quite often. That starts to turn tax deferred into tax free!!! For many it's been a banger of a retirement plan. Thanks to the Tax Cuts and Jobs Act of 2017!!
  
  Love it!
  0 Reply
Kimi Ho
OP
Member since 2018 · 14 posts · 1 vote
1y
Thanks for the response E.J. Will look into it further.
0 Reply
Kimi Ho
OP
Member since 2018 · 14 posts · 1 vote
1y
Hi Dave, thanks for all the information. I thought that would have been the case hence posted here to clarify. In that case, it would make more sense to hold onto it for a bit longer to reduce the taxes more.
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Ashish AcharyaBusiness Member
CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
1y
@Kimi Ho Since the property was acquired via a 1031 exchange in 2020 and converted to your primary residence in June 2024, you may qualify for a partial capital gains exclusion under Section 121 if you sell after June 2026 (meeting both the 5-year ownership and 2-year use tests).
However, the gain will be prorated, and the period it was used as a rental (2020–2024) is considered nonqualified use, so that portion of the gain is taxable. Additionally, any depreciation claimed during the rental period is subject to recapture at 25%, regardless of the exclusion. While you can reduce your taxable gain, you won’t be able to exclude it all. A detailed tax projection can help clarify your exact exposure before selling.
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