How Can I Convert My 1031 Exchange Property Into Primary Residence?

by Angilina Taylor 1031 Exchange Expert, Tax Consultant

Once investors get aware of the incredible tax benefits of 1031 exchange, they start digging deeper into it. We often come across investors enquiring about tax consequences on doing a 1031 exchange into a primary residence. Like -

'Can I convert my 1031 exchange property into a primary residence?'

'Will I receive tax benefits on the sale?'

'Do I need to rent the property for a specific time before shifting into it?'

In this article, we will focus on whether you can re-purpose your newly acquired replacement property into a primary residence.

The Rules -

There is a rule in section 1031 of the IRC clearly stating that the replacement property must be bought with the intent to use it for business or investment purposes. If you sell a $400K duplex and invest the proceeds in a $400K multi-family apartment, you cannot use the property as your primary residence for at least two years. Plus, you must own that property for five years before putting it for sale to ensure you enjoy the benefits of section 121.

You must be wondering now, 'am I able to defer all of the taxes when I sell the property?' Though you can still receive the benefits of section 121, you may not be able to enjoy the tax-deferral benefits of a 1031 exchange.

Let’s consider an example:

Jonathan bought a $300K rental property using a 1031 exchange. To qualify for a 1031 exchange, he rents it out for approximately three years. This rental period ensures the IRS will look at this as property acquired for business or investment purposes.

Just prior to completing his three-year ownership mark, Jonathan decides to move into the property and makes it his primary residence. He stays there for over two years, after which he qualifies for the benefits of section 121.

If Jonathan sells his property using a 1031 exchange, will he owe any taxes? Unfortunately, he will.

So what does Jonathan owe?

Depreciation, depreciation recapture, capital gains, basis, section 121 exclusion, can all be taken into consideration. All these depend upon the amount carried over from the sale of the relinquished property.

In simple words, he won’t be liable to pay taxes on this property, but he will have to pay it on the last property. It is so because the last property was exchanged for a replacement property. Whereas, he has partially used this property for investment and somewhat as his primary residence.

It is a bit difficult to calculate the taxes Jonathan will owe. It varies wildly depending upon her situation, the basis in the property, and depreciation received. Sometimes, it makes sense to continue renting, while on other occasions, it’s better to move in. The flexibility of section 1031 and section 121 is perceptible through this, and we advocate investors take full advantage of the tax-deferral opportunity that accompanies these sections.

Conclusion

If you own a 1031 exchange property that you want to turn into your primary residence, we highly recommend contacting a 1031 exchange expert. It can lead to significant tax complexity, but if done correctly can save your enormous wealth.