How Does Home Equity Loan Impact 1031 Exchange?

Question

Good afternoon! I have a question that I am hoping you or if you know someone that can help answer. If I decide to do a home equity loan on my primary residence and then convert it into an investment rental property next year but still expect to hold it for at least 5 years, how will that impact my 1031 exchange? Let's say if I have $360K mortgage balance now and when applying for a home equity loan, the appraisal comes back with $700K market value. That being said, I would be allowed to take out $165K cash based on 75% LTV. My debt would increase from $360K to $525K. Then when I decide to execute 1031 exchange, I wonder how does my home equity loan impact the value I must carry over to my replacement property? What's the value I will be required to spend on my replacement property? $700K ($525K debt and $175K equity) or $535K ($360K debt and $175K equity) after paying off the home equity loan in full at closing? I have not been able to find an answer to this question. Your help is greatly appreciated.

Dave Foster · Answer

Account ClosedThat proration between qualified and non-qualified use comes from the Housing Assistance Tax Act of 2008 and is used when a property has been converted from a rental to a primary residence not from primary residence to rental.  And if the property has been converted from rental to primary and was previously part of a 1031 exchange there is the added requirement that you have owned the property at least 5 years.

You will have to recapture depreciation on the time when your property was a rental but after that recapture you will be eligible for the entire primary residence exclusion.  That's why that 5 year window is so key when converting from a primary to rental.  You're getting 3 year of appreciation and rental income essentially for free.

Dave Foster · Answer

Account Closedthat debt would be treated as any recorded mortgage.  Upon sale it would be paid off and the remaining cash would go into your exchange account.  You would still have the two requirements of

1.purchasing at least as much as you sell (the net sale or roughly 700K)

2. use all of the proceeds in the next purchase (roughly 175K).

If you keep that property as  a rental for no more than three years after living in it for two years you would be able to sell it and still qualify for the primary residence tax free exclusion even though it is a rental at the time of sale.  The key is that you have to have lived in the property for two out of the previous 5 years.  So live in it for two.  Rent it out for 3.  Make sure you sell before the 5 year mark.  And you could take the first 500K in profit tax free.  So you may not even need a 1031.

Account Closed · Answer

Gotcha. Very good explanation. Thanks for all your help. @Dave Foster

Account Closed · Answer

@Dave FosterThanks for your response. I really appreciate it. So, in other words, I will have to purchase $700K worth of a replacement property with $525K debt and $175K equity cash or higher purchasing amount. Correct?

As for Section 121, I know that I would have to live in my primary residence for at least 2 years out of the preceding 5 years to be eligible for $250K capital gain exclusion (or $500K for a couple). However, it is my understanding if I decide to rent out in the 3rd-5th year, then $100K ($50K each year x the first 2 years I have lived in) will be excluded from tax but the 3rd-5th year, meaning $150K ($50K x last 3 years) will be taxed because I do not live there as my primary residence as it is being rented. No?