1031 Exchange Primary residence

[Nimit A.]

I have a question for which I couldn't find the answer to easily. I am in the current situation:

I bought a property for x in CA and now the property is worth X+y where y is >> 500k therefore I have to pay a lot of taxes on the profit (I am married so the tax exemption should be 500k). My question is this- what if I rented out the property for a year, 1031 exchanged the property into another one and then started living in the new one; would I have to pay any taxes? Or would I have avoided the extra tax that I would have incurred over the 500k? 

[Dave Foster]

@Nimit A., What you're suggesting is a very common  and powerful strategy that actually lets you get the best of both sec 121 (primary residence) and 1031 (investment).  Once you convert the property to investment you'll want to use it for investment long enough to demonstrate that your intent was to hold for investment use.  There is no statutory period.  There is a safe harbor from the IRS at 2 years under certain conditions.  A lot of folks feel that more than a year suffices.  But there could always be circumstances where a longer or shorter hold period would be advised.  In any event you'll need to make sure that you calculate your dates carefully so you sell while you can still claim residence for 2 out of the 5 years prior to sale.  Doing the reverse when you purchase a new property will have the same level of intent that you'll need to demonstrate.

When you sell the property you will start a 1031 exchange but take $500K boot immediately.  Normally this will be taxable but since you qualify for sec 121 your accountant adjusts your return so it is tax free.  The remainder goes into the 1031 and when you meet all the 1031 requirements you will defer all remaining tax and depreciation recapture.

As @Patrick Hermans said the 1031 defers only.  But it actually defers indefinitely and there are several ways that you can use this to your advantage life long while never having to pay the tax.  And in CA's tax environment that's a whopper of a savings.  And like kind does not mean type for type.  It means any kind of investment property for any other investment property.  Income production by rent is not a "like kind" criteria.