1031 Exchange to Rental then Convert to Primary

Investor · Carrollwood, FL (33618) · Member since 2014 · 9 posts · 0 votes

Hi I have searched for a bit and can't find an answer to my specific situation.

I am selling a rental property and would like to 1031 exchange the proceeds into a new rental property. If I do this and later decide to move into the new rental property (making it my primary) will the deferred taxes come due?

I have come across articles that seem to imply that if the replacement property is in service as a rental for at least 2 years I won't be in violation of the 1031 exchange rules and avoid paying the taxes. Not sure if I am interpreting this correctly.

Thanks for the help!

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Dave FosterBusiness Member

Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes

@Bart H., There was much spirited discussion over this one recently. @Nicholas Aiola and I were having this exact discussion.

My understanding is that that all depreciation since 1997 has to be recaptured unless it is a primary residence that has been converted to investment and then depreciation in the last years after conversion but prior to the 121 sale do not have to be recaptured.

The question that may still not be answered in this new tax era is that about the Investment turned primary turned investment with a 1031 thrown in the middle.

So will the service go back to original use or last use. Last use is consistent. But never say never.

@Natalie Kolodij, You're the CPA go to on this thread. Whatdaya think?

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Matt K.
Walnut Creek, CA · Member since 2015 · 3k+ posts · 2k+ votes
8y
@Dave Foster is all things 1031............

From my understanding it's intent rather than firm rules..... So yea if you buy a property and intend for it to be a rental and then years later life happens and you have to move into it your fine.

If you buy it with the intentions of it being your primary then you're likely using the 1031 outside of what it was meant for...
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
8y
@Matt K. nails it @Richard H.. It's all about your intent. If you were ever audited and the Service decided that you did a 1031 with the intention of purchasing your primary residence then your exchange would fail. But selling an investment property doing a 1031 and buying an investment property and then later changing that investment property into your primary residence is perfectly fine and does not trigger a taxable event.
The article you probably read was probably built around a safe harbor for allowable personal use of an investment property for your intent to hold for investment (Rev Proc 2008-16). A two year period is part of that safe harbor. So most folks have concluded that if you hold that rental for two years as an investment you have satisfactorily demonstrated your intent. However safe harbors are not prescriptive and there are others who think a year is OK. The key is going to be in your intent and how you can demonstrate it.
But in any event it is a fantastic model as a way to turn some of that deferred 1031 tax into tax
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Richard H.
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Investor · Carrollwood, FL (33618) · Member since 2014 · 9 posts · 0 votes
8y
@Dave Foster and @Matt K. thanks for the reply. Hopefully I'll have a chance to put this strategy into action.
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Natalie KolodijBusiness Member
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Tax Strategist| National Tax Educator| Accepting New Clients · Member since 2014 · 3k+ posts · 4k+ votes
8y
Ultimately there will always be a qualified use allocation since it began life as a business asset.
Meaning even if you live in it 2/5 years as a primary- a portion of the gain won't be taxable. PLUS depreciation recapture, PLUS that super low beginning basis.
Definitely better than just selling the rental- but still going to take some tax hit
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John Paziouros
Investor · Pasadena, CA · Member since 2014 · 8 posts · 2 votes
8y
I fully comprehend what all the members of this blog, have contributed thus far. My question is, if you extend this one step further, and then sell the now, primary residence, which was converted from an investment property, which was acquired through a 1031 exchange, at that stage, would there be any limitations on the $250/$500 owner occupant deduction?
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
8y
@John Paziouros Yes
Once you have lived in the now primary for two years and have owned for at least 5 years (addl requirement when the property was originally a 1031) you may sell.
1 you must recapture all depreciation
2. You get to prorate the gain between periods of qualified use ( as a primary) and non-qualified use ( as investment).
So if you do a 1031, use the property for investment for 2 years and then live in it for 3 years before selling you would get 3/5ths if the gain tax free up to the 250/500 limits of sec 121.
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John Paziouros
Investor · Pasadena, CA · Member since 2014 · 8 posts · 2 votes
8y
Interesting!

Dave Foster, as always, great insight & knowledge! You are an invaluable resource to the BP community!
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Bart H.
Dallas, TX · Member since 2016 · 1k+ posts · 745 votes
8y
Originally posted by @Dave Foster:

@John Paziouros Yes
Once you have lived in the now primary for two years and have owned for at least 5 years (addl requirement when the property was originally a 1031) you may sell.
1 you must recapture all depreciation
2. You get to prorate the gain between periods of qualified use ( as a primary) and non-qualified use ( as investment).
So if you do a 1031, use the property for investment for 2 years and then live in it for 3 years before selling you would get 3/5ths if the gain tax free up to the 250/500 limits of sec 121.
So when you are recapturing all depreciation, you are refereeing to the depreciation both before and after the exchange correct? IE if your prior property had 100K in depreciation, you do the 1031 exchange, there is no tax. then hold the new property for 5 years, two of those you live in it.
Are you saying you would have to recapture that 100K? or just the depreciation from the last 3 years (out of 5) that you rented the new property?
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Brian K.
Member since 2018 · 3 posts · 1 vote
8y
I'm looking for some suggestions or a strategy as I'm somewhat of a novice real estate investor with a couple rentals. However, I've been doing a lot of research on 1031 exchanges and how they work.  My homes are in the Arizona area and are worth less than 300k each, and are still far from being paid off. Here's the story:
1) I bought my current home and turned my first home into a rental about 12 years ago and am considering selling it. I bought it in 1994 and will have capital gains on that period of around 150k, along with depreciation for the 12 yrs.
2) I purchased a 2nd house to rent (intent) last year.
3) realizing I have a lot (from my perspective anyway) of taxes to pay, I'm starting to wish I did things differently...
Questions: (is this possible and does it make sense or is there a better recommendation)
1) Can I do a 1031 exchange reverse this way: sell the first rental house and use proceeds to pay off the mortgage on the 2nd rental house as a 1031 reverse exchange? I know I'm stuck with depreciation recapture, but hope to use the capital gains exclusion.
2) If I do that and keep it for 2 years as a rental, does my cost basis for the 2nd rental basically become the purchase price and my capital gain on the previous house "go away"? I think that's true.
3)   I'm now also considering moving into the 2nd rental house for several years and make it my primary residence. Assuming I don't downsize too much (I recall there's a limit...) from my current house (which is more expensive), does that give me any advantages.
Thank you for your suggestions. I'm struggling to find a way to retire some day and my original plans to use long term rentals and sell them to fund my retirement are not going too well when I consider what i'm going to give up in capital gains when I sell them.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
8y
@Bart H., There was much spirited discussion over this one recently. @Nicholas Aiola and I were having this exact discussion.
My understanding is that that all depreciation since 1997 has to be recaptured unless it is a primary residence that has been converted to investment and then depreciation in the last years after conversion but prior to the 121 sale do not have to be recaptured.
The question that may still not be answered in this new tax era is that about the Investment turned primary turned investment with a 1031 thrown in the middle.
So will the service go back to original use or last use. Last use is consistent. But never say never.
@Natalie Kolodij, You're the CPA go to on this thread. Whatdaya think?
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
8y
@Brian K.,
1. You can certainly 1031 but not into a house you already own. To do a 1031 exchange you much purchase new investment real estate. Paying down a mortgage does not count.
2. Even assuming that 1 would work (which it doesn't) your basis in the old property moves into the new property. So the gain follows you until you either sell without a 1031 and pay the tax, die and your heirs get the property with the basis eliminated, or you end up converting one of your rentals into a primary residence and re classify some of the gain tax free.
3. Moving into the 2nd house could yield some good benefits. You haven't owned it for long so depreciation or the proration from non-qualified use won't be too bad. And by moving in you will get a proration tax free in a bit of time.
I don't see how you can create a good scenario that involves a reduction of debt on that 2nd property without a sizable tax event. But maybe a 1031 from the first into a new investment property would be a good move. Your retirement plan is sound but you will have to factor in taxes if you want to sell. The method that saves the taxes is to 1031 into passive investments that use the deferred tax and equity to generate income rather than by selling.
Another option is a every two years or so primary conversion from a rental. That will get you at least a portion of the gain tax free.
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Brian K.
Member since 2018 · 3 posts · 1 vote
8y
Thanks Dave, I appreciate all the info. I have just a few more clarifications/questions...
Regarding 1): I was thinking that the 'reverse' 1031 gave people the ability to buy the 2nd house first an still work the 1031 plan somehow. My thinking was to have the EAT move money from selling the first into the mortgage of the second, or put both into the same LLC (one is already) to avoid it hitting ‘my hands' as a taxable event. Is the reverse 1031 not applicable here?
Regarding 2):  Just to summarize my understanding of your response earlier: Even if i did/could do a 1031 exchange, it just makes my cost basis in the second house effectively make it appear (for tax purposes) like i paid less for it than i did( E.g., if i had cap gains of 100k on the previous house then i would end up with my second house cost basis being the cost of the 2nd house-100k. Is that concept about right? So the 'gain' just passes forward but never goes away.
Regarding 3): You mention proration tax over time. For a typical 1031 exchange, are you referring to me living in the 2nd home for at least 5 years (I think this is the correct min. number)  where my previous cap. gains would drop down to 0 vs. living in the home for 2 years where it'd drop 2/5th? Is this basically reversing the past capital gains over time?
New item 4) Would you mind explaining a little more what you mean by: "The method that saves the taxes is to 1031 into passive investments that use the deferred tax and equity to generate income rather than by selling." E.g., what passive investments are you referring to: REIT stocks... ?
Last but not least :-) The last sentence in the reply seems to be missing a word or two, I'm not quite sure...
Thanks again for all the info, you're the best!.
Brian
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
8y
@Brian K. wow you’re packing a lot into a Little post. Here’s the 10000 ft brush and we can pm to go deeper
1. Areverse would work but the eat has to be set up by your QI. It seemed that you already owned the 2nd property. If you already own it then it can’t be part of your 1031
2. Yes the basis carries forward so if you ever sell without a 1031 you’ll pay all the deferred tax,
3. Nope the rules are different when you sell a house under 121 after a 1031 and converting it from investment. The gain is prorated between investment and primary residence use. Own it for 5. Rent it for 2 then move in for 3 and sell. You would get 3/5th tax free and recapture depreciation.
4. These are NNN Tene RA in common syndications or Delaware statutory trusts- completely passive but 1031 compliant. Like Reits but not a reit. Reits do not qualify for 1031.
Last- just missing the letter n to match the adjective “every”. You can do a 121 sale once every two years. So your retirement plan can be a series of new houses that you periodically sell and get some of the gain RA. Free.
Whew
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Brian K.
Member since 2018 · 3 posts · 1 vote
8y
Thanks Dave. Whew is right.
I'll go and stew over all that for a while. Oh, you're assumption was right, I do currently own the 2nd house (I bought it last Sept., it sounds like it's too late.)
So much to learn, so little time, :-)
Brian
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