1031 exchange into a primary residence?

Question

Hi all,

I'm thinking about doing a 1031 into a rental (that I will likely) turn into a primary residence. Any key bits of information I need to know before I do this transaction, Kevin mentioned in my introduction post that I may need to have it as a rental for a couple of years. Any other tips I should know?

The (not so) short version is I have a rental (one of 2) that I bought with a 1031, to further confuse you I bought a house a few years ago I did a 1031 exchange and bought two homes now I'd like to get rid of one or both of them.

Happy to expand or clarify.

Johnny Lujan · Answer

I’d be careful here because the intent and timing matter a lot.

A 1031 replacement property needs to be acquired for investment or business use, not as a disguised primary residence purchase. So if you exchange into the new property, I’d want it treated like a real rental first: listed for rent, rented at fair market rent, reported as a rental, limited personal use, separate records, etc.

Kevin’s “couple of years” comment is probably referring to the common safe-harbor approach. For a dwelling unit, many advisors like to see it rented for at least 14 days at fair rent in each of the two 12-month periods after the exchange, with personal use limited to the greater of 14 days or 10% of the rented days. That is not the only possible way to prove investment intent, but it is a cleaner fact pattern.

Also, if you later convert the property to your primary residence and eventually sell it, don’t assume the full Section 121 home-sale exclusion will apply. Property acquired through a 1031 generally has to be owned for at least 5 years before the Section 121 exclusion is available, and gain can still be limited by depreciation recapture and nonqualified-use rules.

A few things I’d clarify with your CPA before doing anything:

• When did you acquire each property through the prior 1031?
• Have both properties been operated as true rentals since acquisition?
• Are you selling one, both, or exchanging again?
• What is the adjusted basis and depreciation taken on each?
• Are you trying to move into one of them soon, or only eventually?

This is one of those areas where the tax result depends heavily on the timeline and facts. I’d map it out before selling or converting either property.

Ashish Acharya · Answer

Hey John, 1031 is always a great strategy if the circumstances make sense, but like others mentioned above, there are some specific rules that govern how it works, and getting the sequencing right really matters.First, on the exchange itself, just keep in mind that under Rev. Proc. 2008-16, the IRS has a safe harbor for treating a dwelling as investment property. You need to rent it at fair market rent for 14+ days in each of the first two 12-month periods after closing, and keep your own personal use under the greater of 14 days or 10% of the days it's rented. So if you've done this on your current properties, you're most likely good. And you've done this before, so you probably knew this already

On turning the rental into a primary part, the answers above are accurate. I'd make sure you rent it out using those same rules as above and rent it out for those 2 years everyone else mentioned. Also, keep in mind the 121 exclusion probably won't be able to be used at all unless you've owned it for at least 5 years, full stop and even then you probably won't be able to get the full exclusion tax-free. That clock starts at the exchange, so your 2 years of renting count toward it, not against it.

Definitely keep in mind depreciation recapture and non-qualified use rules, like Jason mentioned. You might also want to keep in mind how these properties have been playing into your overall tax picture and other types of income, and how the reinvestment will. You don't want to miss out on any tax-saving opportunities. If your current CPA isn't real estate-focused, I'd definitely double-check your structure with someone who is.

Good luck and happy to connect!

Dave Foster · Answer

@John Johnson,  @Ashish Acharya just nailed the details as usual!  There's a absolutely nothing wrong with this scenario.  It could actually fit in nicely where you plan a series of 1031s followed by conversion to primary as a way to eliminate some of the tax as you go.  This takes strategy and planning.  But can be a great opportunity.

Dave Foster · Answer

@John Johnson, the key here is your intent to hold for productive use or business and how you demonstrate that intent. You're allowed to convert your investment property to your primary residence at any time.  But it must be a conversion of a property you intended to hold for productive use.  Being able to demonstrate this is asked, is crucial.  There is a safe harbor at 2 years as @Johnny Lujan said. It also inludes some use criteria during the 2 year period.  But this is not a statutory holding period.  And there could be situations where a hold of less (or more) would be prudent., and investors who eventually want to retire in one of their investment properties will do this. Your job is to build a good paper trail.

Another key is to plan this ahead of time because the conversion will create an opportunity to eliminate some of the deferred taxes down the road.  And you might want to do this a few times as you move through life.  But navigating on how to maximize the amount of deferred gain and avoiding as much depreciation recapture as you can will take planning.  But this is a splendid strategy to couple with your 1031 exchange.

John Johnson · Answer

Productive use as in it's being purchased as a rental correct?

My intent is to buy something a little nicer than our current rentals in the $300k range, put a real tenant in it for a year (but I can wait for 2) and have the option of down sizing into it. In all reality in a few months of living tin that home we will know if we will be staying long term and repeating the process in 5 years or so.

John Johnson · Answer

Is there anything that I've mentioned that is questionable as long as it's a bonified rental for at least 2 years?

Jason Malabute · Answer

The thing to be careful about here is intent and timing, because a 1031 replacement property has to be bought to hold as an investment, not as a primary residence in disguise. Right after the exchange I'd treat it like a genuine rental: list it and rent it at market rate, report it as a rental, keep your personal use minimal, and keep clean, separate records. The "couple of years" you heard about is the safe harbor people lean on: owning it for at least 24 months and, in each of the two 12-month periods after the exchange, renting it at a fair rent for at least 14 days while keeping your own use under the greater of 14 days or 10% of the days it's rented. Also don't count on the full home-sale exclusion later. When a property came out of a 1031, you generally have to own it at least five years before that exclusion is available, and even then depreciation recapture and the nonqualified-use rules can shrink how much gain you actually get to exclude. This one really lives and dies on your specific dates and numbers, so I'd map out the timeline with your own CPA before you sell or move into either one.

John Johnson · Answer

Great information, thanks. It is my intent to live in that home but in all reality I've bought a couple other homes with that same intent and it's never come to fruition, between my wife and our life it hasn't happened yet.

John Johnson · Answer

Great information than. The 2 current properties have been rentals for the last 5 years and I'll be sure that their replacements are rented for at least 2 and we'll see what happens.

We'll be meeting with our cpa next week so I'll broach this topic with him.

1031 exchange into a primary residence?

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