Many people know about the primary residence exclusion that allows them to take the first $250,000 in profit ($500,000 if you’re married) tax free after just two years of occupancy. And more and more people are learning about the opportunity to do that repeatedly. But, did you know that you can convert an investment property into your primary residence and take advantage of that tax break? Even if you used a 1031 Exchange into your investment property, it’s still an option.
Converting from Investment to Primary Residence
Here’s the deal on converting investment property into your primary residence:
- If you purchased the investment without a 1031 Exchange, you may change its use at any time. Simply use the property as your primary residence for two of the five years immediately preceding its sale.
- If you purchased the property with a 1031 Exchange, there are some special rules for the conversion and the exclusion is prorated.
Converting after a 1031 Exchange
As you may recall, you cannot use a 1031 Exchange to purchase a property you intend to use for your primary residence. You must use the 1031 to purchase property you intend to use for investment purposes.
However, you can convert a 1031 property into your primary residence after holding it for productive use in business or trade for a period of time. The key is:
- your initial intent to hold it for investment purposes and
- how you demonstrate that intent.
For example, if you 1031 into a property and then move right in, what was your demonstrated intent? To use it as your primary residence. Both your initial stated intent and your actions subsequent to purchase are key.
Special Rules after a 1031 Exchange
If you 1031 into a property and then use it as a rental for the next 24 months and do not use it for personal use more than 2 weeks or 10% of the number of days it is actually rented, then the IRS gives you a safe harbor and will never challenge your initial intent. In between day one and two years, there is a wide range of time for you to decide if you’ve owned it long enough and treated it as investment enough that you can change your intent and move in. An awful lot of folks feel good at anything more than a year. But, individual circ*mstances could allow a shorter (or longer) investment use period.
When you do convert the property into your primary residence, you will then get the benefit of the primary residence exclusion with some 1031 Exchange specific requirements.To qualify for any of the primary residence exclusion, you must have owned the converted property for no less than five years. In addition, you must have lived in it for two out of the five years prior to sale. And then you get to prorate the amount of gain between the period of “qualified use” (as a primary and tax-free) and “non-qualified use” (as an investment and you would pay tax on this portion). You also have to recapture all depreciation.
The Bottom Line
The conversion of an investment property into a your primary residence is an underutilized option that can be very beneficial. Over time, it can make the capital gains tax on your former investment property dwindle. This give you the opportunity to take all or a portion of your home sale proceeds tax-free.
Questions? Give us a call at 850-889-1031 or find a mutually convenient time via our online scheduler.
As always, consult with your accountant to determine the best course of action for your financial situation.
FAQs
When a property has been acquired through a 1031 Exchange and later converted to a primary residence, the owner faces a mandatory five-year hold period before having the ability to sell obtaining the Section 121 exclusion. The taxpayor still must satisfy the minimum two of five-year occupancy as primary residence.
Can you convert a 1031 property into a primary residence? ›
If your 1031 exchange allows you to defer recaptured depreciation tax, you can convert a replacement property into your principal residence. You will still face all previously deferred recaptured depreciation upon sale.
What happens when you convert a rental property to a primary residence? ›
You can convert a rental property into a primary residence, but several things will change. Not only will you not be eligible for certain tax deductions, but you may also be able to save money on your mortgage and homeowner's insurance.
Can you do a 1031 exchange from an investment property to a second home? ›
The safe harbor for a vacation or second home to qualify as Relinquished Property in a §1031 exchange requires the Exchanger to have owned it for twenty-four months immediately before the exchange, and within each of those two 12-month periods the Exchanger must have 1) rented the unit at fair market rental for ...
When should you not do a 1031 exchange? ›
The two most common situations we encounter that are ineligible for exchange are the sale of a primary residence and “flippers.” Both are excluded for the same reason: In order to be eligible for a 1031 exchange, the relinquished property must have been held for productive in a trade or business or for investment.
What happens when you convert a 1031 exchange to primary residence? ›
When a property has been acquired through a 1031 Exchange and later converted to a primary residence, the owner faces a mandatory five-year hold period before having the ability to sell obtaining the Section 121 exclusion. The taxpayor still must satisfy the minimum two of five-year occupancy as primary residence.
Can I convert an investment property to primary residence? ›
Yes, it is possible to move into a 1031 exchange property as your primary residence. If you acquire a replacement property but change your mind about how you want to use it, the Internal Revenue Service (IRS) will tax your capital gains for selling the other property.
What is the gain exclusion for personal residence converted to rental property? ›
Many people are aware of the advantages of Internal Revenue Code Section 121, which allows a married couple to exclude up to $500,000 of gain on the sale of their personal residence ($250,000 for a single taxpayer).
Can I move into my rental property to avoid depreciation recapture? ›
For example, some investors consider moving into a rental property and using the home as a primary residence for at least two years before selling. While a primary residence qualifies for a gain exclusion of $500,000 (or $250,000 if single), the depreciation recapture tax liability does not get wiped out.
Can I use rental income from the current residence that is converting to an investment property? ›
By converting your existing home to a rental property, you can use the future rental income to offset the cost of your current mortgage, then qualify for another mortgage based on your adjusted debt-to-income ratio.
Incompatible: 1031 Exchanges and Flipping
Internal Revenue Code Section 1031(a)(2) explains it pretty clearly. Specifically, property that is “held primarily for sale” doesn't qualify for 1031 exchange benefits. This is because it doesn't meet the IRS like-kind exchange criteria of “held for trade or investment.”
Can I assign a property in a 1031 exchange after I've already bought it? ›
Typically, a 1031 exchange involves exchanging relinquished properties with like-kind replacement properties. However, as an investor considering using 1031 funds to build on property you already own, you must equip yourself with the proper knowledge or work with a knowledgeable QI who can guide you through the steps.
Can you do a 1031 exchange twice? ›
There is no restriction on the number of times you can participate in a 1031 exchange. As long as you meet all the requirements and have an experienced intermediary by your side, you can use this tool as often as possible to minimize your capital gains taxes.
What voids a 1031 exchange? ›
If an investor touches any of the money made when she sold a property, she will immediately be subject to paying taxes. Spending the money or moving it into an investor's account would incur penalties; such actions void the 1031 exchange.
What makes a 1031 exchange fail? ›
Tax deferral is the goal of every 1031 exchange, but sometimes, despite the best efforts of exchangers and QIs, exchanges can fail. Often, this is because the exchanger doesn't identify a suitable replacement property within the allowed 45-day window.
What is better than a 1031 exchange? ›
A Deferred Sales Trust (DST) offers an alternative to a 1031 exchange, providing more investment options without the like-kind reinvestment conditions and timeline restrictions.
Can I use a 1031 exchange property for personal use? ›
In layman's terms, this boils down to three key points: Hold the replacement property for at least two years. Rent the property at fair market value for 14 days or more, for each of the two years. Personal use should not exceed the greater of either 14 days per year or 10% of total days rented out for the year.
What are the IRS rules for a 1031 exchange? ›
Using a 1031 tax-deferred exchange requires advance planning.
- Replacement property should be of equal or greater value to the one being sold.
- Replacement property must be identified within 45 days.
- Replacement property must be purchased within 180 days.
What is a Reverse 1031 Exchange? A “reverse” exchange occurs when the taxpayer acquires the replacement property before transferring the relinquished property. A “pure” reverse exchange, where the taxpayer owns both the relinquished and replacement properties at the same time, is not permitted.
How do I change my second home to primary residence? ›
How to Convert Your Second Home to Your Primary Residence
- If you had other people living in your second residence, get them to leave. ...
- Put all the utilities in your name. ...
- Forward all the mail to your new primary home. ...
- Notify your employer, banks, and insurance agents of the move.
