1031 Exchange into a rental and then primary residence?

4 Replies

Hey guys,

We have a friend that just sold a rental property and made $120,000. His plan is to 1031 exchange it into a rental in another location. After two years, they want to make this their primary residence. Is this legal?

Thank you,

Jesse

@Jesse Daconta , Yep. One of the great opportunities. When you do a 1031 exchange you are selling an investment property and purchasing a property you intend to use for investment purposes. But you do not have to keep that intent forever. There is actually a safe harbor for converting a property from investment to your primary from the IRS at two years. And once they've lived in that property for two years and have owned it for 5 years they'll be able to sell it and get a prorated amount of that gain tax free!!!

Hopefully they set up their 1031 exchange prior to the sale.  Otherwise it is too late at this point.  the qualified intermediary must be in place prior to the closing of the sale.  But if they're savvy enough to know this strategy they're probably fine.  

  • Thank you for the reply Dave! I also found (from the FARR Law Firm)this for anyone who's interested:

Guidelines to Convert 1031 Exchange Property into a Principal Residence

The principal question is your intent when you acquired the replacement property. If you sincerely intended to treat it as investment property and not to move into it at the first opportunity, then you are on the right track. How can you prove that intent? If you can't meet the safe harbor test discussed below, the best way is to actually use the property for investment purposes for a significant period of time after its acquisition. If you rent the house out at fair market value for at least a year (according to some commentators), then you likely have shown you acquired the property with investment intent. If you merely put up a good show, on the other hand, such as listing it for rent at an amount that is significantly higher than market, or not even listing it at all, the IRS will see right through that.

Other common sense evidence of intent can be gleaned from a review of the case law (i.e., other people’s mistakes):

  • Don’t have plans drawn up for your principal residence or a vacation home just before or after the exchange.
  • Don’t move into the house right after the exchange, even on a temporary basis.
  • Don’t make the contract to acquire the replacement property contingent upon the sale of your principal residence.
  • Use a reasonable and significant amount of advertising or listings in order to rent the property at a marketable rental amount.
  • Document how you arrived at the asking price of the rent.
  • Don’t start construction on preparing the house for your personal use right after acquiring it.
  • Make sure that the restrictive covenants of the replacement property (or condo documents) allow it to be rented out.
  • Document your efforts to rent the house out including names and contact information for potential tenants who looked at it. You may need to call them as witnesses!
  • If you have a change of circumstances that caused you to move into the house, make sure to document that. Did you unexpectedly lose your job, get sick, disabled, divorced, married, or have to take in an elderly parent?

As mentioned above, the IRS has provided a safe harbor for determining how long a replacement property must be held as a rental before converting it into a primary residence or vacation home without invalidating the prior exchange. The replacement property must be owned for at least 24 months immediately after the exchange (the qualifying period) and in each of the two 12-month periods in the qualifying period: (1) the taxpayer must rent the replacement property to another person at a fair rental for 14 days or more; and (2) the taxpayer’s personal use of the replacement property must not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at fair rental. It can be rented to a family member as a principal residence so long as market rent is paid.

In order to qualify for the Section 121 exclusion of gain, you must use the home as your principal residence for at least 2 of the last 5 years prior to its sale. Also, Section 121 has a special rule for 1031 property that states that you have to own the home for at least 5 years (either as 1031 property or principal residence) before you sell it. Finally, the amount of the exclusion you can claim will be prorated between the period of time it was your principal residence and the time that it wasn't, and any depreciation you took will be taxable.

This is an area where each person’s facts and circumstances are different, so before you get too far down the path of converting a 1031 exchange property to a principal residence, spend some quality time with your tax advisor.

@Paul Moore , SSSSHHHH!  Prior to 2008 you got 100% of the gain tax free.  So rest assured, the IRS is nibbling away at the edges.  Nothing good has ever been accomplished that the Govt. can't mess up or take away!