From 1031 Exchange to Primary Residence

4 Replies

I am a financial adviser and some clients asked me this last night and I don't know the answer. Hoping y'all can help.

Clients own a home (SFR) in South Carolina. The mortgage is paid and it has been a rental property since 1994. Lots of capital gain and depreciation expense taken.

They are planning to retire to Florida in a few years. They have a SFR in Florida selected for their retirement. They wanted to know if they can do a 1031 exchange of their S.C. property for the Florida property now, use the FL property as a rental for a couple of years, and then retire to FL and live in the FL property.

I guess the real question is what are the tax consequences for converting your 1031 property into a primary residence?  Is there some minimum length of time it has to be a rental before converting to a primary residence can be done without immediate tax consequences?

Also, they live in VA, own a property in SC and want to exchange it for a property in FL. Where should their QI be? (Or does it matter?)

TIA.

@Paul Allen , We see a lot of that exact strategy down here.  Their plan is perfectly fine.  A two year period as a full time rental of their replacement property would satisfy the IRS safe harbor.

Simply converting the property by moving in after that period would not trigger a gain recognition by itself.  Once they are ready to sell that property after a period of years they will have some restrictions on the amount of tax free gain they will get.

1. In order to sell it and get a portion of the gain tax free when they eventually sell they will have to have owned it for at least 5 years because it was originally the product of a 1031 exchange.

2. They will have to have lived in it for 2 out of the five years prior to its sale in order to qualify it for the 121 exemption.

3. They will have to recapture depreciation during the time it was a rental.

4.  When they do sell they will have to prorate the gain between the periods of qualified use (as their primary) and non-qualified use (when it was a rental).  

So if they did a 1031 into a nice FL rental and used it as rental for 2 years and then moved in and lived in it for 3 years they could sell and take 3/5ths of the gain tax free up to the limits of sec 121 after they recapture depreciation.

It's not the total windfall it was in the early 2000s but it's still a great opportunity to mitigate some of the pent up gain from 1031ing over the years as a retirement strategy.

Hi @Paul Allen

Yes, they can 1031 Exchange into the Florida property as long as their intent is to hold the Florida property for rental, investment or business use. Their intent can always change in the future and they could convert the property from a rental property into their primary residence. 

However, the critical component here is that they must have the intent to hold the property for rental purposes. They would need to be able to demonstrate under audit that they did in fact have the intent to hold the property for rental purposes rather than ultimately move into the property as their primary residence. If it could be demonstrated that their original/ultimate intent was to always use the property as their primary residence, their 1031 Exchange transaction could be disqualified.

The key is to ensure that their intent is to hold for rental purposes and to document their intent through emails with their advisors. 

National Qualified Intermediaries can administer 1031 Exchange transactions in most if not all states. The location of the Qualified Intermediary is not really that important.

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