Converting a 1031 Exchange Property into a Primary Residence
Carl E. Sera, CMT
May 21, 2021
As we’ve discussed many times before on this blog, you can only do a 1031 exchange on property that is held for investment or business use. Property that you hold primarily for personal use cannot be utilized in a 1031 exchange. So, your primary residence would generally not be accepted as qualified property in a like-kind exchange.
Take for instance, what if your intentions change after you have acquired the replacement property? Is there a point at which you can move into the replacement property and convert it to your principal residence? And if you reside in it and own it the required periods of time, can you use IRC Section 121 to exclude up to $250,000 of gain ($500,000 for married persons filing jointly) on the sale of your principal residence? It can be done, but the key is your intention at the time you acquired the replacement property.
Guidelines to Convert 1031 Exchange Property into a Principal Residence
The principal question is your intent when you acquired the replacement property. If you sincerely intended to treat it as investment property and not to move into it at the first opportunity, then you are on the right track. But how can you prove that intent?
If you can’t meet the safe harbor test discussed below, the best way is to actually use the property for investment purposes for a significant period of time after its acquisition. That is, you simply rent the house out at fair market value for at least a year (according to some 1031 experts), then you likely have shown you acquired the property with investment intent.
Other common-sense show of intent can be gleaned from a review of the case law (i.e., other people’s mistakes):
- Don’t have plans drawn up for your principal residence or a vacation home just before or after the exchange.
- Don’t move into the house right after the exchange, even on a temporary basis.
- Don’t make the contract to acquire the replacement property contingent upon the sale of your principal residence.
- Use a reasonable and significant amount of advertising or listings in order to rent the property at a marketable rental amount.
- Document how you arrived at the asking price of the rent.
- Document your efforts to rent the house out including names and contact information for potential tenants who looked at it. You may need to call them as witnesses!
- If you have a change of circumstances that caused you to move into the house, make sure to document that. Did you unexpectedly lose your job, get sick, disabled, divorced, married, or have to take in an elderly parent?
In the past, taxpayers used to be able to trade into a rental, rent the home for a while, move into it and then exclude all or some of the gain under Section 121. Provided they lived in the home as their primary residence for at least two years, they could sell it and exclude the gain under Section 121 up to the maximum level of $250,000/$500,000. Recently, Congress amended Section 121 in order to limit the benefits of Section 121 when the property has also been used as a rental.
First, if you acquire property in a 1031 exchange and then convert it to your primary residence, you must own it at least five years before being eligible for the Section 121 exclusion.
Second, the amount of gain that you can exclude will be reduced to the extent that the house was used for something other than a primary residence during the period of ownership. The exclusion is reduced pro rata by comparing the number of years the property is used for non-primary residence purposes to the total number of years the property is owned by the taxpayer.
For example, a married couple uses a tax deferred exchange under Section 1031 to acquire a house as investment property. The couple rents the house for three years, and then moves into it and uses it as their primary residence for the next three years. The couple sells the property at the end of year 6, netting a total gain of $800,000. Instead of being able to exclude $500,000, the couple will not be able to exclude some of the gain based on how many years they rented the house. Since they rented it for three years out of six, 50% of the gain, or $400,000, will not be able to be excluded. Because of this new limitation, the couple will be able to exclude $400,000 of the gain rather than $500,000.
However, there are a couple of exceptions to this restriction. If the house was used as a rental prior to January 1, 2009, the exclusion is not affected. Using the example provided above, if the three-year rental period occurred prior to January 1, 2009, the exclusion would not be reduced and the couple would be able to exclude the full $500,000.
Another important exception is that property that is first used as a primary residence and later converted to investment property is not affected by these restrictions on excluding gain. For example, if you own and live in a house for 18 years and then you move out and rent the house for two years before selling it, you can receive the full amount of the exclusion.
In summary, a 1031 exchange enables you to exchange an existing business use or investment property for a home that you will eventually convert to a primary residence. Of course, you need to maintain the property as a rental for a period of time to satisfy the requirements of Section 1031 but with a little planning and some patience, you could soon be moving into your dream home but be sure to consider your exit strategy in advance.