Personal vs. Investment Property IRS Designation/Classification

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I am looking to turn my personal property into an investment property and then 1031 exchange into a multi-family home. How long do I have to rent out the personal property (do I have to move out or purely rent a room?) to guarantee it is seen as an investment property in the eyes of the IRS? What are the government's qualifications for an investment property? I live in Mpls, MN... does it vary by state?

I searched google and couldn't find an answer so I'm hoping the experts here can! Thanks all. Cheers

@John Moksnes In order to complete a 1031 exchange you will need to show proper intent. The IRS does not have a specific timeframe of how long you should hold the property for rental, investment, or use in a trade or business. With that being said, you may get a range of opinions depending on who you ask. If you rent the property out for at least 24 months (which is probably the most conservative timeframe because it straddles three tax years) you should be in a good position. Some recommend at least renting for 12 months, some say 18. Ultimately, it depends on how comfortable you and your tax advisor are with risk. Renting for 24 months, clearly shows that you had the intent to own that property for rental income.

You could decide to only rent a portion of the property but when you go to do your exchange you can only use the portion/percentage that you rented for a replacement property. Sometimes, this may work well and others, it may be difficult to buy a replacement property with the funds if it's a small portion of the overall property.

You could also combine a 1031 Exchange with the 121 Exclusion. You qualify for the 121 Exclusion if you have owned and lived in the property for at least a total of 24 months out of 60 months. The exclusion allows you to defer $250,000 (single taxpayer) and $500,000 (for a married couple) from your gross income. If your gain exceeds 250k/500k then this may be a another possible solution. Many people who choose to combine the exchange and exclusion will live in the property for two years. Then they'll move out and rent the property for another two years or more. Then place the property up for sale. In this case you could exclude the full 250k/500k from your taxable income, and complete a 1031 on the balance of the transaction to defer the rest of your capital gain.

Please let me know if you have additional questions.

Thanks!

Lauren

This is great info Lauren! I really appreciate the response. 

aren't you exempted from like 250k single/500k married from cap gains on primary, just do it that away. Disregard if you don't intend to house hack the MFH.

Good question Matt. If I sell it and let's say the net gain from the sale is $200k, does that income then pass onto my personal tax return for the year (and I'm taxed on it) or is it completely tax exempt?

Thanks for the responses. I really appreciate it!!

@John Moksnes    You will need to report the sale on the tax return, but if requirements are met, $200K will not be taxed.

That's the section 121 exclusion @Lauren Speidel mentioned above ---> (pasting from her post) You qualify for the 121 Exclusion if you have owned and lived in the property for at least a total of 24 months out of 60 months. The exclusion allows you to defer exclude $250,000 (single taxpayer) and $500,000 (for a married couple) from your gross income.  

I changed defer to exclude because deferral implies you may need to include in income or pay tax later, but with sec 121, there is no tax if you qualify and your gain does not exceed the limits.

@Tatyana S. @John Moksnes   Thank you! Wrong word choice there. The taxpayer would not be responsible for paying that portion back. It is excluded.

Thanks all! That's great news and makes the execution of my strategy a bit easier. For future planning purposes, do you know if the 24/60 months rule applies to a family member of the owner of the property? Ex. My son eventually lives in my rental property while in school at university and then take advantage of section 121 to avoid the cap gains tax?

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