In order to qualify for capital gains tax deference under the Internal Revenue Code Section 1031 exchange, both the property you are selling (the relinquished property) and the one you are acquiring (the replacement property) must be held for productive use in a trade or business or for investment purposes. This rule is also referred to as the qualified purpose requirement.
Going by the above stated IRS rule on 1031 exchange, a primary residence is typically not held for trade or investment purposes; therefore it doesn’t meet the qualified purpose requirement.
But what happens if your intention changes after you have purchased the replacement property? Can you at any point move into the replacement property and convert it to your primary residence? And if you reside in it for a specific period, can you use the section 121 to exclude $250,000 of gain ($500,000 for married persons filing jointly) on the sale of your principal residence?
The answer to the above questions is yes, it can be done. You can move into your replacement property and convert it to your primary residence while still using section 121 to exclude certain portion of the gains. However, you must prove to the IRS that you purchased the replacement property solely for investment purpose and that certain circumstances made you make the move into the replacement property.
Guidelines to Convert Your 1031 Exchange Property into a Principal Residence
Like we mentioned above, the major factor the IRS looks at is your intent when you purchased the replacement property. If you truly intended to treat the replacement property as an investment property and not move into it upon purchase, then you are surely on track with the IRS rules. But the question is how can you show that intent to the IRS?
One of the best ways to prove that intent to the IRS is to actually put the property up for investment use for a dedicated period upon its acquisition. If you put up the replacement property investment for rent at a fair market for at least a year, then you most likely have proven to the IRS that you purchased the new property with investment intent.
Remember that if you want to play a fast one on the IRS by listing the rent for a price higher than the market value or not listing the home at all, the IRS will see through such a deceit. Below are some clear ways to prove intent based other peoples experiences and 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.
- Don’t start construction or preparing the house for your personal use right after acquiring it.
- Make sure that the restrictive covenants of the replacement property (or condo documents) allow it to be rented out.
- 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?
As we discussed above, the IRS have stipulated on how long a replacement property must be held as a rental before it can be converted to a primary residence without affecting the previous exchange.
The replacement property must be owned for at least 2 years immediately after the exchange (the qualifying period) and in each of the two 12-month periods in the qualifying period: (1) you must rent the replacement property to another person at a fair rental for 14 days or more; and (2) your personal use of the replacement property must not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at fair rental. You can rent the home to a family member so long as market rent is paid.
In order to be eligible for the section 121 exclusion of gain, you must use the replacement property as your primary residence for at least 2 out of the last 5 years before its sale. Furthermore, a part of the section 121 in regards to 1031 exchange properties requires that you must own the home (either as a 1031 property or your primary residence) for at least five years before you sell it. The amount of exclusion gain you can take out will be prorated between the periods it was your primary residence and the time it wasn’t. The IRS will also factor in any depreciation you may have taken out over the years.
This is a complex procedure and your situation is likely different from the next person. Before you start the journey of converting your 1031 exchange property to a primary residence, you should reach out to a qualified tax advisor.
Please note – Sera Capital is not a tax advisor, we’re registered investment advisors. Please talk to your accountant. This is not a recommendation.