1031 to primary residence conversion strategy

3 Replies

While listening to a Guru selling dreams, I heard something that really caught my interest.  Here is the situation described:

1.  Investor X has 5 rental houses that he has acquired over the last 15 years and is ready to retire.  All 10 houses have gobs of depreciation stank all over them and he wishes to 1031 exchange them into the next property.

2.  Investor X decides to sell all 5 houses at the same time, and uses a 1031 fiduciary to retain all proceeds from sell.  Investor X then goes out and identifies 3 nice properties in Vail, Colorado that he wishes to purchase within the 45 day period.  The purpose of the properties he has identified will be used as a vacation rental.  

3.  Investor X buys the ski property in Vail, Colorado for 499K with his proceeds from the 5 houses he sold from the 1031 exchanges (within the 180 day window) and sets up the vacation rental and starts renting it out for 3 years.

4.   Investor X then decides that after 3 years, he wants to move into the Vail property and make it his primary residence.  He does this, and lives there for 3 years and 1 day.  Then, he decides to sell the property for 498K.  He lost 1k on the whole deal :(  

This is the part that got a little muddled for me.  Investor X sells the property in Vail and all of the depreciation stank from the 1031 magically dissolves itself under the 121 code, thus allowing him to end the trail that would normally go to a stepped up basis upon his death.  

What is missing here?    

I'm guessing he becomes liable for the previously deferred taxes, the moment he converts it to a primary residence.  Just a guess.

@Steven Hamilton II   will know better.

He will still be liable for the deferred gains And will have unrelated depreciation.

The home sale exclusion section 121 would only apply to gain after it became a primary residence. 

Section 121 of the Internal Revenue Code will only exclude capital gain, it will not exclude any depreciation recapture.

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