I am curious if a property is bought using a 1031 exchange from another property sell, used as a rental for a period of time, is there any way to turn it back into a primary residence again?
Would you pay back depreciation that year on taxes or at a later date when sell it?
@William Huston , Hello from across the Bay !
You bet! What you're talking about is a conversion. It's a very popular and powerful strategy. There's actually some specific provisions in the code for how to handle it.
First you must make sure that you can demonstrate your investment intent in purchasing the property in the 1031. It cannot be your primary intent to buy the property in the 1031and move in. Your intent must be to purchase and hold as investment. There's no statutory holding period that establishes that intent. There is a safe harbor at 2 years. But there could always be specific circumstances that would justify a shorter or longer holding period.
Second, the conversion process is very simple - you move in and your accountant removes the property from your Schedule E. There is no taxable event associated with moving in. Depreciation is suspended but remains un recaptured. Tax is only triggered upon sale.
Third, now that it is your primary residence you will now have to qualify for the primary residence exemption of sec 121. But there are a couple additional requirements.
1. You must have lived in the property for 2 out of the previous 5 years.
2. because it was the product of a 1031 exchange you must have owned it for at least 5 years.
3. You will only get a prorated amount of the gain tax free. The proration is between the amount of "qualified use" (as primary residence), and "non-qualified use" (as investment). Example - If you purchased it as a 1031 and used it as rental for two years then moved in and lived there for 3 more years you would get 3/5ths of the gain tax free up to the 250/500k limits.
4. When you sell you will have to recapture all depreciation.
Just imagine a retirement job that involved slowly converting investment property into your primary residences in a series of obnoxiously fun retirement places. You do still pay some tax but you also get your principle and a portion of the profit tax free. Not a bad gig!