--- title: Tax Consequences When Converting a Rental Property into a Personal Residence description: Related questions most often arise when a real estate investor is considering the sale of a rental property and wishes to reinvest their 1031 exchange proceeds into a replacement rental property that they eventually wish to move into. image: https://blog.fgg1031.com/hubfs/Taxes%20on%20house.png --- [info@firstguardiangroup.com](mailto:) [(866)398-1031](tel:(866)398-1031) [![fgg](https://blog.fgg1031.com/hubfs/FirstGuardianGroup_2022/fgg.png)](https://brokercheck.finra.org/individual/summary/6470002) [![fgg-871923](https://blog.fgg1031.com/hubfs/FirstGuardianGroup_2023/fgg-871923.png)](https://www.bbb.org/us/ca/san-jose/profile/commercial-real-estate/first-guardian-group-1216-887513) [![logo](https://blog.fgg1031.com/hs-fs/hubfs/FirstGuardianGroup_2022/logo.png?width=175&height=56&name=logo.png "logo")](http://fgg1031.com) - [Home](https://fgg1031.com/) - [About Us](https://fgg1031.com/about-us/) - [Current Offerings](https://fgg1031.com/property-listings-directory/) - [Resource Center](https://fgg1031.com/resource-center/) - [Glossary](https://fgg1031.com/glossary/) - [Accommodators](https://fgg1031.com/accommodators/) - [FAQ](https://fgg1031.com/faqs/) - [Tax eBook](https://pages.fgg1031.com/resources/real-estate-tax-deferral-strategies-ebook) - [Real Estate eBook](https://pages.fgg1031.com/real-estate-investing-in-the-new-era2) - [QI eBook](https://pages.fgg1031.com/resources/qualifiedintermediary/ebook) - [Tax Calculator](https://fgg1031.com/tax-calculator/) - [Newsroom](https://fgg1031.com/newsroom/) - [Blog](https://blog.fgg1031.com/blog) - [Events](https://fgg1031.com/events/) - [Contact Us](https://fgg1031.com/contact/) ![search-interface-symbol](https://blog.fgg1031.com/hubfs/FirstGuardianGroup_2022/search-interface-symbol.png) ![loader](https://f.hubspotusercontent-eu1.net/hubfs/24949188/Business%20and%20Finance/global/22.gif) ![close](https://blog.fgg1031.com/hubfs/FirstGuardianGroup_2022/close.png) From Pages From Blog Pages Load More Load More **Sorry, we couldn't find a match for  "".** Check your spelling or try a related search term. 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Related questions most often arise when a real estate investor is considering the sale of a rental property and wishes to reinvest their 1031 exchange proceeds into a replacement rental property that they eventually wish to move into. In this blog post, we’ll explore how to successfully accomplish such a conversion and address potential tax consequences. #### **Important Steps to be Followed** ### *Property Selection* Investors who plan a future move into a rental property will likely exercise more care and require more time in the selection of the [replacement property](https://fgg1031.com/property-listings-directory/)than when selecting a property that will remain as an investment property. In many cases, they will identify the replacement property and tie it up before they begin selling their relinquished property. To be certain that the replacement property remains available, they may consider completing a reverse 1031 exchange wherein they work with a [Qualified Intermediary](https://blog.fgg1031.com/blog/qualifications-of-a-qualified-intermediary)who will purchase the property on their behalf and hold it pending the completion of the sale of the relinquished property. 1 ### *Meeting the 1031 Exchange Like-Kind Requirement* Once the exchange is completed and the replacement property is acquired, it is critical to follow these rules to avoid challenges from the tax authorities: - The investor must develop proof that the property was purchased with an intent that it initially be held for business or investment purposes. This is most easily accomplished by renting the property at a prevailing market rate for a minimum of two tax years and filing annual Schedule E tax returns for the income received.2 - Limited personal use of the property is permitted provided that such usage does not extend beyond either 14 days or 10 percent of the total number of days the property was rented during a 12-month period. We have heard of cases where investors acquire a replacement property and do make a sincere effort to rent it out of concerns that having a tenant may complicate their move in strategy. If the property remains vacant - perhaps by offering it above market rates, or failing to follow-up on inquiries from potential tenants, red flags are likely to go up if the exchange is audited.  Investors should also avoid documenting their intention to eventually move into the property prior to completing their 1031 exchange. Waiting two years doesn’t cure a written statement of an intention to make it a personal residence. It is best to document a change of circumstances after acquiring the property. For example, a year and a half to two years after the purchase you need to move closer to your parents to take care of them. Or the house you currently own has stairs that you can no longer easily climb, and it makes more sense to move into the rental property than buy a new residence. Tax advisors are not pleased representing a client who has a bunch of emails talking about how they plan to buy rental property and convert it to a residence two years from now.  The property can also be rented to a family member provided that fair-market rent is being paid and reported to the tax authorities.  Having a solid paper trail along with support from a tax advisor is the best way to establish that the intent of the exchange was to initially acquire the property for business for investment use. Once the two-year holding period has been met, the investor can then move into the property. ### *Conversion of Rental into Personal Residence* The conversion is formally completed when the investor has updated their personal records e.g., driver’s license, bank accounts, credit card statements, voter registration, post office notice, etc. to reflect their new residence address. The converted property is no longer reported on a 1040 Schedule E tax form but on the Schedule A form where you will be reporting property tax and mortgage interest deductions.  #### **Tax Implications** Tax considerations are generally derived from two separate sections of the tax code, IRC Code Section 1031, and IRS Code Section 121.  ### *1031 Exchange Impact* The desired outcome of the 1031 exchange is to fully defer taxes owed upon the sale of an investment property into the future and potentially avoid them altogether if the investor passes and the property is passed onto [successors](https://blog.fgg1031.com/blog/1031-exchanges-for-estate-planning-absolutely).3 Once the property has been converted into a personal residence, the tax obligations associated with the prior 1031 exchange remain (bad news) but (good news) they will not need to be paid until the replacement property is sold in the future. Also, the capital gain portion of 1031 tax obligations may be partially reduced through taking advantage of additional tax exclusions available under IRS Section 121. ### *The 121 Tax Exclusion * [IRS Section 121](http://www.law.cornell.edu/uscode/text/26/121) was created in 1997 and allows owners of personal residences to exclude up to $250,000 of gain on the sale of their residence - or up to $500,000 for a married couple who files jointly. To qualify, the homeowner(s) must own and use the home as their primary residence for a total of any 2 of the past 5 years.  In order for rental properties that have been converted to primary residence to qualify for the Section 121 exclusion, they must have been owned by the taxpayer for at least five years.   A partial exclusion may be available if the property is sold in less than two years if there were “unforeseen” circumstances that created a need to sell such as a change of employment, or health matters, among others. The amount of allowed exclusion is pro- rated over the period that the homeowner lived in the property. For example, if the home was a personal residence for 18 months, the allowed exclusion for a married couple would 18 months/24 months or 2/3 times $500,000 or $333,333.  The 121 exclusion only applies to capital gains and cannot be used to offset depreciation recapture or the 3.8% net investment tax (aka Obama Care tax).  #### **Combining a 1031 Exchange with a 121 Exclusion ** *“I wish to sell a current rental property and complete a 1031 exchange into a rental property that I will convert to my personal residence later. Can I combine the benefits of a 1031 exchange with a 121 exclusion to minimize my overall tax burden?”* Quite possibly – but the savings may not be as great as you think since the 121 exclusion is pro-rated over the combined holding period of the relinquished property and acquired property. It is best to answer this question by providing a detailed example. Be forewarned that this example is a bit complex and may lead to further questions that are best answered by a qualified tax advisor.  #### Example4 Alex purchased a rental property (“Property A”) on January 1, 2011, for $440,000. He owned it for five years and decided to sell and complete a 1031 exchange to purchase another rental property that he eventually planned to convert to his personal residence. At the time of sale, he was deferring $60,000 in capital gains, and $20,000 in depreciation recapture.  To complete his 1031 exchange, Alex purchased a residential replacement (“Property B”), on January 1, 2016, for $500,000 and rented it for two years. On January 1, 2018, the tenant moved out and Alex moved in and converted it to his personal residence.  On January 1, 2020, he moved out and rented it again. He then sold the property for $800,000 on January 1, 2021.  At time of sale, Alex therefore had a $300,000 capital gain on the sale of his primary residence, Property B, and an additional carry-over gain of $60,000 from the sale of rental Property A for total taxable capital gain of $360,000.  Alex also had depreciation recapture of $30,000 on Property B plus carryover depreciation recapture of $20,000 from Property A.  ### *Calculation of the Allowed 121 Exclusion* Alex owned Property A and Property B for a total of 10 years. The allowed 121 exclusion only applies to the portion of when the properties were used as a personal residence. To recap, Property A was rented for 5 years, and Property B was rented for 3 years. Since Alex converted Property B to his personal residence for only 2 years, he would be allowed to only apply 2/10 or 20% of his allowed $250,000 exclusion or $50,000 to reduce his taxable capital gain.  Furthermore the $50,000 reduction would only apply to his capital gain and would not reduce his tax obligations related to deprecation recapture or payment of the net investment tax (3.8%).  See this summary below:![](https://blog.fgg1031.com/hubfs/image-png-Jul-28-2022-01-38-12-51-PM.png) #### **Bottomline** The conversion of a rental property into a personal residence can be an attractive option for investors to consider – especially if they plan to downsize or relocate to a new area. By combining 1031 tax deferral strategies with the allowed 121 exclusion of capital gains on a personal residence, overall tax obligations can be potentially reduced.  Executing these strategies should be undertaken with the assistance of a knowledgeable real estate tax advisor. #### **Next Steps** To learn more about tax deferral and investment strategies please [schedule a meeting](https://meetings.hubspot.com/pgetty) with our professionals at First Guardian Group at 866 398-1031 or email us at [info@fgg1031.com](mailto:info@fgg1031.com).   --- #### Have you downloaded our ebook? [![](https://no-cache.hubspot.com/cta/default/5468919/interactive-183026367846.png)](https://blog.fgg1031.com/hs/cta/wi/redirect?encryptedPayload=AVxigLJSjUJuB32ZT%2FR0stjSe607Bq15G%2BYWNjOuQtJ7Y9tEueINUxejiqQWHS%2BLVr5R8amIDjdMVgI6Sv7t8UVRuqL1NWPBRtkSAEMzyQm7eQAfwqB3%2BPiFgmbNHBqFgKb2QS1t8SQoLxM9NeeD1iIzc1tqzsPGTsFcIeih0q2NAdLWoB0q3L0Zqt%2Fh9%2F6ClkTOXL3%2BMidAde14TzRCcfliFUQUuGX0JUa12pLCtRyNt%2Fgp&webInteractiveContentId=183026367846&portalId=5468919)   Disclaimer: *First Guardian Group, LightPath Capital, Inc and their representatives do not provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional.* 1 A reverse 1031 exchange must be completed within 180 days of the purchase date of the replacement property. See this blog for more information on reverse 1031 exchanges: [https://blog.fgg1031.com/blog/the-reverse-1031-exchange](https://blog.fgg1031.com/blog/the-reverse-1031-exchange)  2 IRS [Revenue Procedure 2008-16](http://www.irs.gov/irb/2008-10_IRB/ar12.html) provides guidelines for the holding period. The two-year timeframe is not absolute and there are cases where a shorter time frame was permitted (TC Memo 2012-118 (April 23, 2012). 3 An adjustment in the cost basis of an inherited rental property to its fair market value on the date of the investor’s death results in a forgiveness of capital gains tax obligations and is called a “step-up in basis.” **4** We would like to thank real estate tax guru, Ray Simmons, for his assistance in helping us to develop this example.  --- ##### **Help Save 1031 Exchanges** Write to your Member of Congress and Senators urging them to oppose restricting Section 1031 like-kind exchanges. As part of the American Families Plan, the Biden Administration has proposed eliminating the application of Section 1031 for gains greater than $500,000. Like-kind exchanges have been part of the U.S. tax code since 1921 and are one of the tax code’s most powerful economic tools. It is critical that we all vigorously and visibly oppose this proposal. Make your voice heard with a pre-filled letter, which you can customize to add personal anecdotes or powerful client stories to highlight the positive impact of Section 1031 like-kind exchanges. Take action today by clicking [HERE](https://p2a.co/XLBiUYT)[**.**](https://p2a.co/XLBiUYT) --- ### [Paul Getty](https://blog.fgg1031.com/blog/author/paul-getty) Paul M. Getty is one of the most experienced 1031 exchange specialists in the United States, with a career in real estate that spans over 35 years and more than $5 billion in commercial transactions across every major asset class. His work covers single-family rentals, apartments, retail, office, multifamily, and student and senior housing, giving him a practical understanding of how different property types perform across market cycles and how investors can move between them using tax-deferred exchange strategies. As President and CEO of FGG1031 | First Guardian Group, Paul advises investors through the full 1031 exchange process, from identifying qualifying replacement properties to structuring acquisitions through Delaware Statutory Trusts (DSTs) and wholly owned real estate. His guidance covers both the compliance requirements of a valid exchange and the investment decisions that determine long-term portfolio outcomes – a combination that is difficult to find in a single advisor. Paul holds a California and Texas real estate broker license and carries Series 22, 62, 63, and 82 securities licenses as a registered representative with Emerson Equity LLC, member FINRA /SIPC. He has represented buyers and sellers across complex commercial transactions, sourced and structured debt and equity, and worked alongside nationally recognized firms including Marcus Millichap, CBRE, JP Morgan, and Morgan Stanley. Before founding FGG1031, he co-founded Venture Navigation, a boutique investment banking firm whose M&A and IPO activity generated over $700 million in investor returns. Paul holds an MBA in Finance from the University of Michigan and a bachelor’s degree in chemistry from Wayne State University. He has also completed coursework in artificial intelligence at Stanford University. He is the author of four books on real estate investing and tax deferral strategy, including Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST) and Real Estate Investing in the New Era, both available on Amazon. A frequent speaker on 1031 exchanges, DST investing, and real estate tax strategy, Paul Getty is a recognized voice for investors and advisors seeking guidance on capital preservation through tax-deferred real estate investment. ## Your Comments : This is a search field with an auto-suggest feature attached. - There are no suggestions because the search field is empty. - Latest Posts - Popular Posts [Partial 1031 Exchange: How It Works, What Gets Taxed, and When It May Make Sense](https://blog.fgg1031.com/blog/partial-1031-exchange-how-it-works) [ 1031 Exchange](https://blog.fgg1031.com/blog/topic/1031-exchange) [721 UPREIT Options in DST Programs (Part 3)](https://blog.fgg1031.com/blog/721-upreit-options-in-dst-programs) [ Real Estate Investors](https://blog.fgg1031.com/blog/topic/real-estate-investors) [ DST](https://blog.fgg1031.com/blog/topic/dst) [ 721 Exchange](https://blog.fgg1031.com/blog/topic/721-exchange) [ UPREIT](https://blog.fgg1031.com/blog/topic/upreit) [ New featured](https://blog.fgg1031.com/blog/topic/new-featured) [Can a 9% Taxable Return Beat a 4.5% Tax Advantaged DST?](https://blog.fgg1031.com/blog/can-a-9-taxable-return-beat-a-4.5-tax-advantaged-dst) [ Real Estate Investors](https://blog.fgg1031.com/blog/topic/real-estate-investors) [ DST](https://blog.fgg1031.com/blog/topic/dst) [ New featured](https://blog.fgg1031.com/blog/topic/new-featured) ### Categories - 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October 20, 2022](https://blog.fgg1031.com/blog/what-is-a-springing-llc) ## Useful Links - Home - About Us - Blogs - Testimonials from Past Customers - Resource Center - Current Offerings Disclaimer: There is no guarantee that any strategy will be successful or achieve investment objectives. All real estate investments have the potential to lose value during the life of the investments. This material does not constitute an offer to sell nor a solicitation of an offer to buy any security. Such offers can be made only by the confidential Private Placement Memorandum (the “Memorandum”). Please be aware that this material cannot and does not replace the Memorandum and is qualified in its entirety by the Memorandum. This material is not intended as tax or legal advice so please do speak with your attorney and CPA prior to considering an investment. This material contains information that has been obtained from sources believed to be reliable. However, FGG1031, First Guardian Group, LightPath Capital, Inc., and their representatives do not guarantee the accuracy and validity of the information herein. Investors should perform their own investigations before considering any investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) and 1031 Exchange properties. These include, but are not limited to, tenant vacancies, declining market values, potential loss of entire investment principal. Past performance is not a guarantee of future results: potential cash flow, potential returns, and potential appreciation are not guaranteed in any way and adverse tax consequences can take effect.  The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. All financed real estate investments have a potential for foreclosure. Delaware Statutory Trust (DST) investments are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments. Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions. Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits. IRC Section 1031, IRC Section 1033, and IRC Section 721 are complex tax codes; therefore, you should consult your tax and legal professional for details regarding your situation. DST 1031 properties are only available to accredited investors (generally described as having a net worth of over one million dollars exclusive of primary residence) and accredited entities only (generally described as an entity owned entirely by accredited individuals and/or an entity with gross assets of greater than five million dollars). If you are unsure if you are an accredited investor and/or an accredited entity, please verify with your CPA and Attorney prior to considering an investment. Securities offered through registered representatives of [LightPath Capital, Inc.](http://www.lightpathcapital.com/) Member [FINRA](http://www.finra.org/) / [SIPC](https://www.sipc.org/). FGG1031, First Guardian Group, and LightPath Capital, Inc. are separate entities. Copyright 2022, All Rights Reserved, FGG1031 [![FGG_Footer_White](https://blog.fgg1031.com/hs-fs/hubfs/FirstGuardianGroup_2022/FGG_Footer_White.png?width=300&height=95&name=FGG_Footer_White.png "FGG_Footer_White")](http://fgg1031.com) 97 East Brokaw Road, Suite 350, San Jose, CA 95112 [(866) 398 1031](tel:(866)%20398%201031) [info@firstguardiangroup.com](mailto:) [![Bitmap](https://blog.fgg1031.com/hubfs/FirstGuardianGroup_2023/Bitmap.png)](https://brokercheck.finra.org/individual/summary/6470002) ## Recent Blogs - [Understanding the Difference Between Inheritance and Estate Tax August 3, 2023](https://blog.fgg1031.com/blog/understanding-the-difference-between-inheritance-and-estate-tax) - [Public or Private Real Estate? Your Investment Portfolio May Need Both July 27, 2023](https://blog.fgg1031.com/blog/public-or-private-real-estate-your-investment-portfolio-may-need-both) - [How to Use 1031 Exchange Funds to Improve Your Replacement Property July 20, 2023](https://blog.fgg1031.com/blog/how-to-use-1031-exchange-finds-to-improve-your-replacement-property) ## Useful Links - [Home](http://fgg1031.com/) - [About Us](https://fgg1031.com/about-us/) - [Blogs](https://blog.fgg1031.com/blog) - Testimonials from Past Customers - [Resource Center](https://fgg1031.com/resource-center/) - [Current Offerings](https://fgg1031.com/property-listings-directory/) FGG1031 | First Guardian Group and Emerson Equity LLC do not provide legal or tax advice. Securities offered through [Emerson Equity LLC](http://www.emersonequity.com/) Member [FINRA/SIPC](http://finra.org/) and MSRB registered. Emerson Equity LLC is unaffiliated with any entity herein. 1031 Risk Disclosure: - There is no guarantee that any strategy will be successful or achieve investment objectives; - Potential for property value loss – All real estate investments have the potential to lose value during the life of the investments; - Change of tax status – The income stream and depreciation schedule for any investment property may affect the property owner’s income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities; - Potential for foreclosure – All financed real estate investments have potential for foreclosure; ·Illiquidity – Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments; - Reduction or Elimination of Monthly Cash Flow Distributions – Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions; - Impact of fees/expenses – Costs associated with the transaction may impact investors’ returns and may outweigh the tax benefits No offer to buy or sell securities is being made. Such offers may only be made to qualified accredited investors via private placement memorandum. Risks detailed in a private placement memorandum should be carefully reviewed, understood and considered before making such an investment. Prospective strategies and products used in any tax advantaged investment planning should be reviewed independently with your tax and legal advisors. Changes to the tax code and other regulatory revisions could have a negative impact upon strategies developed and recommendations made. Past performance and/or forward looking statements are never an assurance of future results. Many of the investments offered will be only available to those investors meeting the definition of an Accredited Investor under SEC Rule 501(A) and offered as Regulation D private placement securities via a Private Placement Memorandum (“PPM”). Prospective investors must receive, read and understand all of the risks associated with buying private placement securities. Investments are not guaranteed or [FDIC](http://fdic.org/) insured and risks may include but are not limited to illiquidity, no guarantee of income or guarantee that all tax advantages or objectives will be met and complete loss of principal investment could occur. **Risk Disclosure:** Alternative investment products, including real estate investments, notes & debentures, hedge funds and private equity, involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor's interest in alternative investments, and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-U.S. exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in U.S. markets. Additionally, alternative investments often entail commodity trading, which involves substantial risk of loss. NO OFFER OR SOLICITATION: The contents of this website: (i) do not constitute an offer of securities or a solicitation of an offer to buy of securities, and (ii) may not be relied upon in making an investment decision related to any investment offering by FGG1031 | First Guardian Group, Emerson Equity LLC, or any affiliate, or partner thereof. FGG1031 | First Guardian Group does not warrant the accuracy or completeness of the information contained herein. Copyright 2026, All Rights Reserved, FGG1031