Rules around converting a rental to primary residence

6 Replies

Hey all,

We're facing another crossroads with what to do in terms of a 1031 exchange that my parents and I co-own (which I also live in with my wife and kids) with our current place and selling it in exchange for a place that's a little bigger. They have another property (in the Bay Area) that they are wanting to get rid of and had the idea of folding that into this 1031 exchange, however the heavily tenant-favored laws in the Bay Area are working against the current timeline and they either have to pull out of that idea or defer it. 

Currently we are leaning towards holding off on the 1031 exchange and just moving to the area we want to live in (South OC) and rent for a year. This would buy my parents time to figure out how to proceed with evicting the tenant up north (this could be a year long process anyway). This would also mean that we would seek to rent out the current co-owned property for about the same amount of time. My dad suggested that 1) we take all the rental income and 2) they transfer the deed/title to be solely in me and my wife's names. 

Can someone go over the caveats of both those suggestions? Can we really just collect the full rental income? Don't we technically need to "split" it based on ownership %? 

Also, another point of concern is if we 1031 exchange this property (regardless of whether they transfer deed/title or leave it as is) + my parents' other Bay Area property into a single property down down here. If we did that, would we be required to rent that new property out for a certain amount of time else risk disqualification of the 1031 exchange?

Double disqualified. 

You can’t 1031 a property your living in, only investment properties.  

You can’t 1031 in to a property you’re going to live in, only investment property. 

I don’t know why your parents are considering giving you some property but you’d be tax the same as if they gave you the cash as opposed to tax free at death. Of course you’re also assuming the tax liability. 

Rephrasing the last part of the question in a different way: if the target replacement property (per the 1031 exchange) is still co-owned between my parents and I (let's assume it's a property purchased @ $900k and they own $400k of it from their 1031 proceeds and we own $500k from our 1031 proceeds), could we immediately make it our primary residence (after closing on it) and pay them fair market rent based on their % of ownership? Or would our $500k ownership interest be disqualified as a 1031 and we would then have to pay capital gains taxes on that amount?

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Thanks Bill Brandt. I should clarify that the property we are living in as far as the co-ownership aspect is based on my parents rolling over a prior investment property that I think was $300-325k. The current property was purchased at $525k, so to supplement they put in some more of their own funds and then I put in the downpayment and have a small private loan taken to buy-back additional ownership (25%) in the property. It's fully a 1031 property as far as their interest in it is concerned but our 25% portion is not. If we were to currently sell this under this arrangement, they would be 1031ing their 75% interest and we our 25% interest would just be sold as non-1031 assets. But I think if we were to move out and rent elsewhere, then rent this place out, our 25% portion of interest in the property would then be considered rental and if we were to go to sell later and attempt to tax-defer the gain (though it would be minimal), it would still have to be considered a 1031 rollover.

How long do you have to rent out a 1031-exchanged property before you can convert it to a primary residence? I'm assuming people do this (e.g. when downsizing etc) but I'm just not familiar with the timelines.

Here's another thought I'm wondering about as far as avoiding the 1031 conflicts on our part: what if we just quitclaim deed our interest in the current property so that it's fully in my parents' names? Then they can do whatever they want and then later could fold both properties into one and we would just rent from them (and or buy back additional interest in the property if we want to co-own later). The reason they want to do this is two-fold: 1) they're getting older and want to reduce the # of properties and tenants they would have to manage in the longer-term 2) if they have to have a tenant, they'd prefer it to be an easy arrangement: us living in one of their rental properties would fulfill this requirement. For all intents and purposes, if we could make this happen it would be a win-win I'm pretty sure.

I don’t think renting from your parents would be considered arm’s length. 

Unfortunately everything you’re posting is specifically saying “we are going to do this in the future...this is our specific plan...” your “plan” is supposed to be buying investment properties and exchanging them to other investment properties. If some “unforeseen circumstances”  occur you could try to justify your moving in to an exchange. But posting on a public forum in advance that you are going to do it is going to make the “unforeseen” part hard to defend.

Will you “get away with it”? Probably, if the tax savings are small enough, the rest of your taxes are simple, you don’t do anything else shady. Probably the worst that can happen is taxes and penalties assuming it’s a one time thing and they don’t prosecute for fraud. Make sure you discuss that part with your parents and your cpa to avoid any appearance of financial elder abuse. 

Make sure your not creating tax bills with all the “gifting” of property with quitclaims one way or the other. At least you’re not throwing in doing all this through a SDIRA. :-)

@Jeremy Lee, You need to bounce the idea of moving out of the current property and quic claiming it to your parents.  For one thing your accountant might let you take the 121 exemption.  For another you and your parents need to understand the impact of any gift claiming now and what's going to constitute a taxable. Event.  

What does work though is if your parents do a 1031 or a couple of 1031s into a property that they own and you rent from them at market rate. You write rent checks, They collect rent checks and report rental income.  Done this way it's easy to argue that they are treating their property as investment.