1031 Exchange rental to New rental then to Principle Residence?

Question

Can I use a 1031 Exchange to buy another house, then "put it in service as a rental" for a short period of time of 6 to 12 months. After renting it for 6-12 months, then evict the tenants and move in as my new principle residence.  I will then sell my old principle residence with no capital gains?  Is this legal under 1031 Exchange rules?

Bill B. · Answer

Man, it’s a good day when the “Expert answer” is the answer you want. Thanks again.

Gary Jellis · Answer

I received some good advice from Qualified Intermediaries; Thank you.  I may contact you when I'm ready to committ.  My only other question is how does the IRS consider and weigh a tax payers "intent"?  As you can guess from my post, my intent is to "avoid" paying taxes to the IRS, which is perfectly legal and encouraged tax strategy.  The way I see it, I am only doing the 1031 exchange to avoid taxes, which requires that I put the replacement property in service for a period of time.  If I'm willing to let a stranger live in my personal residence for  6 - 12 months, then I think I earned the tax break.

Dave Foster · Answer

@Bill Brandt, and the BEST day is when your wife's answer is the one. you want!!!

Dave Foster · Answer

@Bill Brandt, That's got to be on of those logical/philosophical conundrums :). Intent is the standard.  Use is how you demonstrate intent.

So in my mind I'm buying an investment property that i might turn into my primary.  Or I will turn into my primary but I will first be using it as investment.   I think the only place you get into trouble with this kind of nuanced thinking is when the time frames are exceptionally tight.  I bought an investment property and thought about it for 10 minutes and decided to change it to my primary residence - looks a little more like something else doesn't it??!!

Interesting enough the safe harbor actually agrees to bypass any interpretation of your intent.  It is a fixed set of use requirements.  And if you meet those the IRS agrees that your situation meets the standard of investment intent automatically.

So that level of use is "guaranteed" (whatever that is) to meet the intent standard.

Bill B. · Answer

Can any one want to weigh in on the outcome of the IRS seeing a post that says my intent is to do this 1031 and then convert it to my primary? Are you still covered by the safe harbor over 2 years? You’ve still shown intent to use the property as a rental at least temporarily.

Bill Exeter · Answer

Hi @Gary Jellis,

It all boils down to your intent.  You must have the intent to hold the replacement property for rental, investment or business use to qualify for 1031 Exchange treatment.  The shorter the hold the more difficult it might be to prove that you really had the intent to hold for rental purposes.

Most advisors recommend at least a one year hold.  I would argue this is true if it is a plain vanilla 1031 Exchange.  If you convert to your primary residence, it might be safer to prove intent if you had a longer holding period.  I would use 2 years so that it straddles three income tax returns to make it much easier to prove intent.  There are reasons such as business, economic, and medical, that can change intent.  There could be a financial argument such as during COVID-19 where someone lost a tenant, etc., and they had to sell their primary residence and move into their rental to survive the economic challenges if they lost their job.  It all boils down to your intent, what you can prove if you are audited, and what/why your intent changed.

Dave Foster · Answer

@Gary Jellis, Probably not.  For starters if you and she file a joint tax return then you are each the same taxpayer no matter who's name is on deed.  So you'd be buying from yourself.  No Go.

If you file separately you'll still run into related party issues and if your married filing jointly you can almost guarantee that the IRS would see this as basis shifting and disallow the exchange if ever audited.

A couple of thoughts

1. Cash flow from paying down debt is almost never as much as cash flow from a mortgaged asset.  So if your goal is cash flow it would be better to keep a real estate asset and the debt in place.  If your goal is security that is when paying down debt is a great option.

That being said there are a couple of other approaches that might work.

1. Your plan at the very beginning of this thread has a lot of merit. Sell your wife's house and 1031 into a really nice rental that you rent for a while and then move in and sell your primary tax free.  Use the tax free money to pay down the mortgage on your other rental.  You reduce debt and don't incur tax on gain.

2. A is a hybrid approach that might work for you.   Sell your wifes rental and 1031 into a passive DST if you can.  These will absorb the debt you have on the property you are selling and convert it to non-recourse debt so it falls off your personal balance sheet. It relieves you of management risk.  And provides monthly cash flow.  You'll still have the debt on your rental.  But will have more cash to offset that.

Gary Jellis · Answer

My wife had a rental property before we were married and she is now thinking about retirement in 2022.  She wants to sell it and but will have a big capital gains tax.  We plan to use the proceeds from the sale of her house to pay-off the mortgage on one of my rentals and then have more cashflow in our retirement years.  Can she use a 1031 exchange to relinquish (sell) her property and then purchase my property as her replacement in order to defer capital gains?  I assume that I will owe capital gains on the sale of my rental.

Dave Foster · Answer

@Gary Jellis,  intent is demonstrated in any number of ways - your past and current practice, stated goals, actual rental income.  Attempts to rent, actual length of time passing before changing use.  Stated reason for changing intent... All of these things can be part of how you demonstrate your intent.

Sean Ross · Answer

This evoked an audible chuckle, Bill.  Very self-aware!

Bill and Dave have you covered with the technicalities.  Let me give you some practical advice based on past/current clients.

• The facts on the ground will trump an email you've sent or a Bigger Pockets post.  If you've a track record of investing in the long-term with your real estate holdings, then I advise engaging with this property in a similar fashion. Time held for investment is only one of many factors.  Your job is to manage your real estate in the best way you see fit.  That's more important than worrying about 9 months vs 15 months vs 24 months. 
• If you're thinking about changing the use of a property due to extenuating circumstances (family dynamics, loss of income, COVID, recession, etc), then it's probably a good idea to log that thought or share that with someone in a durable format. 
• Audits are rare. The IRS is very busy, usually understaffed, etc.  Don't lose sleep over the IRS. They'll do their job, but they aren't "out to get you."  Just prepare intelligently and ask good questions, like you've been doing. 
• Avoid spending a lot of personal time at the property during the investment period. 
• If you want to be conservative, wait the two years.  Make sure that you report it as an investment property and depreciate it on at least two tax returns.

1031 Exchange rental to New rental then to Principle Residence?

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