1031 Exchange my Rental to Current Primary and Move Out??

Question

Hello,

I am curious if anyone has done a 1031 exchange with an existing rental property for their primary residence and converted that property to your investment.

We are looking to upgrade our primary residence (and our investment property). We were thinking about selling our current investment property and doing a 1031 into our primary residence? We would of course move out of the primary and thus make it an investment property.

The reason we were interested doing this is we know the house well, what it does and does not need, and it is nearby where we live. It would also remove the need to quickly find a new property per 1031 requirements.

Curious if anyone has done something like this? Do we need to sell the primary residence to ourselves??

-Jason

Dave Foster · Answer

@Jason Barton, Well you heard it from two of the best - both @Bill Brandt, and @Joe Splitrock are correct.  However, there's a way to thread the needle if you have a little runway.

1. You must exchange from investment real estate to investment real estate and you can't exchange into something you already own.  But you don't have to keep the replacement investment property as investment forever.  As soon as you have owned it long enough to satisfy your intent to use as investment (1-2 years is considered pretty safe.  But there's no statutory requirement for length) you can convert a property from investment into your primary residence.

So if you can slow the model down - sell your rental and do a 1031 buying a really nice investment property you might like to live in one day. Then in a year or two you move out of your current primary and convert it into investment And you move into your investment property you exchanged into and convert it into your new primary residence.

Done right this entire thing would not generate any tax burden for you.  And you'd have the option down the road of actually pulling out some of the former 1031 gain tax free if you ever sell the property you converted into your primary residence.

Dave Foster · Answer

@Joe Splitrock, since the basis follows you in the 1031 you All of that gain would follow into the new property when it is purchased and when it is converted to your primary.  So when you then sell the primary it is the entire gain that will be prorated.  I think that is probably the underlining reason for the 5 year holding period.  That ensures that the Service will recoup at least two years of allocation of gain to tax.

Joe Splitrock · Answer

Just to clarify, do you pay taxes based on the gain from the exchanged property value or from the acquired/converted property value? Can you help with an example? Say that I had a house I purchased for $150,000 and $20K land value. I rent it ten years and it is worth $250,000 when I exchange it into a $300,000 house with $40K land value. I rent it two years and it is now worth $330,000 at which point I move into the property. I live there for five years and sell it. Am I taxed on the gain from the $150,000 original investment? Is the prorated time line based on the 10 years original property plus 2 years or is it just the two years after exchange. It would make a big difference if it was 5/17 versus 5/7. Sorry for all the questions. This could be a good strategy for me down the road, so trying to understand it better.

Dave Foster · Answer

@Joe Splitrock, If @Jason Barton converts his replacement property to primary residence at some point the following criteria will apply.

1. He will have to have owned the property for 5 years

2. He'll have to have lived in it for 2 out of the 5 years immediately prior to selling it.

3. When he sells he'll have to recapture depreciation

4. He'll get to prorate the amount of gain between the time he actually lived in it (tax free) and the time it was investment (taxed.)

I've got clients with investment properties stacked up waiting for them to convert to primary as they move through retirement.  All they have to do is live in it long enough and a big chunk comes to them tax free.  Sure they're going to end up paying some tax.  But they would also pay tax if their retirement gig involved delivering pizza :)

Bill B. · Answer

@Joe Splitrock

If it was a rental first then you owe taxes based on the percent of time it a rental compared to total owned time.

I think what Dave was saying is this would be a way to buy his future primary with the exchange if he lived in his current primary for a couple more years then moved in to the property he exchanged for.

Joe Splitrock · Answer

When you convert a rental to personal, how do avoid taxes from the gain and depreciation recapture? I thought when you sell a personal property that was converted from a personal residence that you are still responsible for taxes on the gain over basis and depreciation recapture. I know you are not taxed on the gain that occurred when it was a personal residence, but I didn't think you could escape taxes from when it was an investment property. Or are you saying 2 of 5 rule resets when you exchange?

Bill B. · Answer

You also can’t convert to something you already own.

Joe Splitrock · Answer

No, it is called "like kind exchange" for a reason. You cannot convent an investment property into a primary residence. Primary residence gain is not taxable (to certain limits), so when you convert to investment property, you convert at a higher basis.

1031 Exchange my Rental to Current Primary and Move Out??

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