Using a 1031 exchange to swap out one investment property for another can give you the flexibility to divest less attractive holdings, diversify your portfolio, or change your investment strategy. This tax provision allows you to defer your capital gains taxes and depreciation recapture, as long as you follow the rules outlined in Section 1031 of the U.S. Tax Code.
One of these rules states that both the relinquished property and the replacement property must be “held for use in trade or business or for investment.”
It’s fairly common for investors to use a 1031 exchange to purchase a single-family or multi-unit residential rental property. However, if your strategy changes, you may wonder whether you can move into the home instead.
It is possible to convert an investment property purchased with a 1031 exchange into a principal residence. However, you must follow IRS rules to avoid having your exchange disqualified and ending up with a large tax bill. Here are a few things you need to know.
Establishing Investment Intent
When determining whether a transaction qualifies for special tax treatment under Section 1031, the IRS considers the taxpayer’s intent. In other words, you must show that you originally intended to hold the property as an investment or for business use, even if you subsequently changed your mind.
While the tax code does not specify a minimum holding period for 1031 exchange properties, the IRS does grant safe harbor to investors who use a property as a rental for 24 months, renting it at the fair market rate for at least 14 days per year. In addition, the property owner must not use the property for personal use for more than 14 days per year or 10% of the number of days it’s rented during each 12-month period.
If you meet these requirements, the IRS will not challenge your initial intent. This can allow you to convert the property to your principal residence without having to worry about a disqualified exchange. However, you may not need to hold the property for a full 24 months. Since there is no stated minimum holding period, it’s possible to convert a property sooner as long as you can prove that your initial intent was to use it for investment or business purposes.
Many experts believe that a holding period of just one year is sufficient. However, depending on your circumstances, you may opt for a shorter or longer holding period.
The Primary Residence Exclusion
Once you’ve converted the property to your principal residence, you also have the opportunity to take advantage of the Section 121 primary residence exclusion. This allows you to exclude up to $250,000 ($500,000 for married couples filing jointly) of capital gains on the property sale. To qualify, you must have owned the property for at least five years and have used it as your primary residence for at least two of the past five years. The two years do not have to be consecutive to qualify.
It’s notable that this exclusion only applies to the gains that were experienced during the time the property was used as a primary residence. Therefore, you must prorate the amount of gain between the time the property was held for “qualified use” (as your primary residence) and “non-qualified use” (as an investment).
The portion of the capital gains attributed to the time the property was held for qualified use can be excluded up to the $250,000 (or $500,000) limit. You would owe taxes on any remaining gains and are also required to recapture all depreciation.
Some Final Thoughts
It’s common for property investors to shift investment strategies. If your plans include converting a 1031 exchange property into your primary residence, keep in mind that failing to show intent can lead to costly tax consequences. We recommend that you consult with experienced tax and legal professionals before making this type of change – and be sure to document related discussions in writing. Doing so can help ensure you remain in compliance with all applicable IRS rules and have written evidence of your intention that may prove helpful should you be audited.
To learn more about real estate tax deferral strategies or request a referral to an experienced real estate tax advisor, give us a call at 866-398-1031 or complete our online contact form now.
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