1031 Exchange to New Rental / New Residence Question

6 Replies

I have been trying to learn all I can about the different real estate strategies and I always like to have multiple exit strategies.  Completely understand in a 1031 exchange the new property needs to be a higher basis value than the one that was sold.  I also understand that the replacement property would need to be a rental as well to qualify.

My question comes with the replacement property and it's use.  If we performed this transaction and acquired a replacement property and had problems with tenants or problems with our primary residence or whatever and had the need or desire to stop renting it after X number of years and instead move into it what would the impact be for the 1031 exchange?  

If it would "violate" the exchange rules, who and how would the "governing body" know or inflict penalties?

The governing body (the irs) is going to know because you’re going to stop declaring rental income and taking depreciation. I BELIEVE you’d want to rent it out for at least a year and have that be your intent. I BELIEVE, if you sold within 5 years of the 1031 exchange it would be ignored and you’d owe taxes on all the capital gains. 

If you’re talking more like rent it out for 3 then live in in for 2 then sell, you’d get a percent of the gain tax free (not 100% because it was a rental first). In this case 40% of the capital gains but you’d still owe all the depreciation recapture. 

You’ll need @Dave Foster  to clear up any mistakes I’ve made. Better yet, use him for your exchange so you have a smart advisor who’s done what you want to do on your side. 

Nothing to clear up there @Bill Brandt .  Well said.  @Wayne Emminizer , converting a property from investment to your primary residence  after x years is not prohibited after a 1031 exchange.  You just have to understand that your intent in purchasing the property in the 1031 must have been to hold for productive.  Your concern needs to be how to demonstrate that intent if ever asked.  

Here's the range - 

1. Do the 1031 complete the purchase and the next day your moving truck backs up to the door with your furniture.  What was your intent?  Obviously to purchase a primary residence - 1031 disallowed.

2. If you used the property for rental for 2 years at least 14 days each year.   Have not used it for personal use for more than 14 days or 10% of the number of days it was rented.  The IRS gives you a safe harbor and guarantees your intent.

3. Somewhere in between.  That's going to depend on the individual situation and what you're comfortable with documenting that your intent was to hold for investment use and then your intent changed.  As @Bill Brandt said a lot of folks feel comfortable at anything more than a year.

But there's a potential issue with your understanding of the first part of the process that could still trip you up.  While the basis of the old property does transfer into the new property that is not your reinvestment target.  If you want to defer all tax you must purchase at least as much as your net sale and use all of the net proceeds in the replacement.   If you only replace your basis in the new property you'll be pulling out your profit and that will generate a taxable event. 



@Wayne Emminizer There is a rule in section 1031 of the IRC clearly stating that the replacement property must be bought with the intent to use it for business or investment purposes. If you sell a $400K duplex and invest the proceeds in a $400K multi-family apartment, you cannot use the property as your primary residence for at least two years. Plus, you must own that property for five years before putting it for sale to ensure you enjoy the benefits of section 121.

Originally posted by @Angilina Taylor :



@Wayne Emminizer There is a rule in section 1031 of the IRC clearly stating that the replacement property must be bought with the intent to use it for business or investment purposes. If you sell a $400K duplex and invest the proceeds in a $400K multi-family apartment, you cannot use the property as your primary residence for at least two years. Plus, you must own that property for five years before putting it for sale to ensure you enjoy the benefits of section 121.


Actually since the property was a rental first then converted to a primary you can't enjoy the benefits of section 121 fully. 

Qualified use applies so if it was a rental for 5 years then you move into it for 1  and then go to sell it.....5/6 of your gain is disallowed under 121. 

The IRS has this rule in place so that people can't rent a house for decades, bank appreciation, live in it for 24 months and sell tax free. They make you account for the business use if that was it's initial purpose. 

Ahhh those were the days @Natalie Kolodij . Pre 2008 that was the holy grail - convert a rental to primary and then take the full 121 money tax free. We ended up with a sail boat paid for with tax free REI dollars.

Just goes to show What Gideon Tucker once said - No ones life, liberty, or property, are safe while the legislature is in session!

Originally posted by @Dave Foster :

Ahhh those were the days @Natalie Kolodij. Pre 2008 that was the holy grail - convert a rental to primary and then take the full 121 money tax free. We ended up with a sail boat paid for with tax free REI dollars.

Just goes to show What Gideon Tucker once said - No ones life, liberty, or property, are safe while the legislature is in session!

 I do love how it took the IRS decades to realize what people were doing though hah

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