Moving into a 1031 Exchange property---at some point?

Question

Hi All,

If someone moves into a property, (a single family - for example) that was purchased through a 1031 exchange years after purchasing it, what would the tax consequences be? To clarify: the purchaser never had an intention of living there but a life event like death or divorce occured and moving into a property they already own makes the most sense.

Thanks!

Ashish Acharya · Answer

There is no tax implication on converting rental/ Investment property as a primary residence. You mentioned, "Years after purchasing it".  The only risk is that IRS might challenge the 1031 exchange.

There is no clear-cut rule on how much time a taxpayer must hold the property for the IRS to consider the taxpayer to be holding the property for productive use. Professionals believe that one year is probably a safe period, six months is risky, three months is very risky, and anything less is likely to be challenged unless there are extenuating circumstances. So you should be good as looks like it has been more than a year and you might have an extenuating circumstance.

Once you the house is a personal residence, if you itemize deduct in your personal return, you get to deduct the mortgage interest and property tax ( capped at 10k). If you take the standard deduction, interest and property tax doesn't matter.

Bottom line is there is no tax implication when you convert the property into PR.  You need to keep track of the basis and depreciation taken to calculate the gain when you finally sell it.

Carl Fischer · Answer

@Fausto Carosella

You no longer get to deduct depreciation and other expenses, you are limited to $7500 in SALT.  When you sell- Depreciation recapture tax for years you rented it is due and then home exemption if you lived in it for 2 out of the last 5 years kicks in —any more $$ after that is long term capital gains. Verify with your cpa including your assumptions. I do think it is a loophole in the system.

Dave Foster · Answer

@Fausto Carosella, That can be a great strategy.  From what you indicated you would have completed the 1031 with the intent to use for investment and at some point in the future decided to change the use and move it.

When you do that there are no immediate tax consequences other than it is no longer reported as investment on your tax return and you lose the depreciation allowance and other investment write offs.  As long as you continue to own that property there will be no recognized gain.

If you later sell after you have owned it for a total of 5 years and have  occupied it for at least two years then you will have to recapture depreciation at that point but you will get to take a proration of the gain tax free for the years you have actually lived in it.

Example - You do a 1031 and purchase a property using it for investment for two years.  Then you move in and live in it for three years and sell.  You would have to recapture depreciation but  You have owned it for a total of 5 years and have lived in it for at least 2 out of the 5 years prior to sale.  So you would get 3/5ths of the gain tax free and would pay tax on 2/5ths of the gain.

Bill B. · Answer

@Fausto Carosella

Not 100% Fausto.  After 2 years renting and 5 years primary. 5/7ths as a percent (a little over 71%) would be tax free up to $250k for singles $500k for married people. The other portion would be taxed as capital gains.

I BELIEVE you would still owe 100% of the depreciation recapture at 25%.

Eamonn McElroy · Answer

@Dave Foster

You're correct.  This is what happens when I read too quickly.  : )

Can't use 121 with a 1031 property until after 5 years of property acquisition.  2/5 still applies.

Eamonn McElroy · Answer

@Fausto Carosella

There are two primary concerns.  First, can you get the 121 exclusion, and second, will you bust your 1031 election doing this?

For the former, IRC Sec 121(d)(10) specifically states that there is a caveat if a like-kind exchange property is converted to a primary residence.  The 2 out of 5 years doesn't apply -- you must meet the ownership and use requirement for the entire 5 year period.

Also note that unrecaptured 1250 gain and non-qualified use exposure exists just like with a normal 121 exclusion.

For the latter, there is a presumption that property acquired in a 1031 exchange will be held for productive use in a business.  A principal residence obviously doesn't qualify as a business asset.

However, there is a rev proc that establishes safe harbor for rentals acquired in a 1031 exchange that are later converted to personal use.  If the taxpayer, for the 24 months after the property is acquired, rents the property out for more than 14 days each tax year at fair market rents and does not use the property for personal purposes for more than 14 days during each tax year, the Service will not challenge the 1031 exchange.

Highly encourage anyone who is thinking about doing this to work with a CPA.  It's easy to bust if you don't know what you're doing or aren't careful.

Dave Foster · Answer

@Bill Brandt, You're on fire.  I need to hire you to blog for me!  Exactly right.  And @Fausto Carosella would have to recapture depreciation.

Fausto Carosella · Answer

Thanks guys!! @Dave Foster @Eamonn McElroy That helps ALOT! and great explanation, and I think I followed accurately.... but out of curiosity in Dave's example: if an owner acquired the property and rented it for two years, then moved in and lived for the next 5 years could they use the 121 exclusion and get the entire gain tax free? (less the depreciation recapture from the years used as rental)

Dave Foster · Answer

@Eamonn McElroy Great synopsis.  One thing that is a little confusing is your statement  from IRC Sec 121(d)(10)  that the 2/5 not applying and that  you must meet both use and ownership test for the the Like-kind/1031 exchange for the entire 5 years.

Isn't the 5 year period immediately following the acquisition in a 1031 exchange the period that you are prohibited from taking the exclusion.  And that if you meet ownership and use tests (2/5) and have owned the property for at least 5 years the exclusion is available under the prorated scenario?

Further from Pub 523.  "If you sold a home that you acquired in a like-kind exchange, then the following test applies. You can’t claim the exclusion if:

1. Either a. or b. applies: a. You acquired your home in a like-kind exchange (also known as a section 1031 exchange), or b. Your basis in your home is determined by reference to a previous owner's basis, and that previous owner acquired the property in a like-kind exchange (for example, the owner acquired the home and then gave it to you); and

2. You sold the home within 5 years of the date your home was acquired in the like-kind exchange."

Am I missing some case law?

Moving into a 1031 Exchange property---at some point?

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