Convert Investment Property to Principal Residence | 1031X (2024)

Many clients ask how to convert an investment property into a principal residence after a 1031 exchange. Converting your replacement property is simple and, with advanced planning, it can be a powerful and strategic tool.

Conversion to a primary residence could increase your tax savings above what a standalone 1031 exchange provides. You can use this as an off-ramp away from active real estate investing without getting punished by the IRS. However, there are some essential considerations to remember (and hurdles to avoid) when making the switch.

Below, we present a quick guide to help you through the process.

The IRS provides many incentives to homeowners and real estate investors, but those incentives are not always equal.The key is to know what tax breaks you are eligible for and how to use them best — especially when it comes time to sell your property.

Your principal residence can be an extremely tax-efficient asset.Homeowners may be eligible for many deductions and credits, such as deductions on mortgage interest and property taxes or credits for energy-efficient improvements.

Investment properties also carry unique tax advantages. You can deduct any repairs, maintenance, and other expenses related to the upkeep of your investment property.The most important benefit is the abilityto depreciate the property and receive an annual tax break. You may be eligible for unique depreciation benefits depending on your property type.

Selling an investment property presents very different tax consequences than selling a primary residence.

You are generally subject to capital gains and depreciation recapture tax when selling an investment property.However, you may be able to defer this tax throughInternal Revenue Code (“IRC”) section 1031.This tax code enables you to exchange the property for another similar investment property without triggering a tax liability. Forthe exchange to qualify for 1031 treatment, the taxpayer must meet specific criteria, including that the exchange must be for investment or business purposes.

If you sell your primary residence,IRC section 121allows for the exclusion of income tax liability — rather than deferral — up to $250,000 ($500,000 for married couples filing jointly) of gain from the sale of a principal residence. To qualify, the taxpayer must have owned and used the home as their principal residence for at least two of the last five years.

Critically, the IRC can apply both tax statutes if you sell property converted from investment use to a principal residence before the sale. If used strategically, taxpayers can maximize the benefits from each.

Practically speaking, it is very easy to convert your 1031 replacement property into a principal residence. You can simply move in and treat it like a primary residence.

There are no direct tax consequences to moving in — you stop reporting the property as an investment asset and begin listing it as your home. Converting does not trigger the recognition of capital gains taxes.

Important note:If the IRS believes you completed your 1031 exchange with the intent of moving into your replacement property right away, it may disallow your exchange and retroactively impose any income taxes, plus penalties. It is often best to “season” a property by treating it properly as an investment asset for multiple years.

There are two major benefits to converting an investment property into a principal residence. First, you get to use the asset directly.Remember that the IRS limits the amount of personal time you spend at any investment property. However, you have no restrictions with a principal residence.

The secondsignificantbenefit, as described previously, is the ability to exclude some or all of the capital gains from taxes when you sell the property. So long as you occupy your principal residence for the mandated time to qualify for the IRC section 121 exclusion, this can mean tens or hundreds of thousands of dollars in tax savings.

Unfortunately for 1031 investors, it isn’t as simple as “move in, sell, then pay no taxes”.

For years, many real estate investors used the tax strategy you might call “first defer, then exclude” to escape from most income tax liability. Before 2008, the taxpayer needed to own and occupy the property as their principal residence for two out of the five years before the 1031 exchange.After the correct amount of time, they would qualify for the section 121 exclusion to convert thereplacement property to a primary residence.

Income tax enforcementwas aware of this tax avoidance, and they have gradually limited this tax strategy. In2005, theTax Increase Prevention and Reconciliation Act (TIPRA)amended the law toenabletaxpayers to qualify for the section 121 exclusion if they owned and occupied the property as their principal residence for two out of the five years following the 1031 exchange.

TIPRA was the culmination of several efforts by the IRS to reign in the “first defer, then exclude” strategy. Before then, the IRS relied on the specific statutory requirement that, for a successful 1031 exchange, both the relinquished and replacement property must be “held for investment.” (IRC section 1031(a)) The IRS could and did arguethatifan individual converted a 1031 replacement property to a principal residence, thistransaction would fail the “held-for-investment” test. (Reesink v. C.I.R., T.C. Memo. 2012-118)

However, the tax courts ruled tomeasure investment intenton the day an individual acquired a 1031 replacement property, after which the IRS realized that the simple use of the statutory language to challenge these transactions was not working. Investment intent, while subjective,relieson facts. Therefore, informed taxpayers would establish an objective investment intent on the daythe individual acquiredthe 1031 replacement property.

For example, a taxpayerwould perform one of the following actions:

1. 1031 exchange into a vacation property into which they eventually planned to move
2. 1031 exchange into a property that was first rented to their children and later gifted to their children
3. 1031 exchange into a property, show a failed effort to rent the property, and move into the property after the failure to rent

Theseexamples would lead to eventual tax exclusion under IRC section 121. Today, the story is much more complicated.

Tomaximize the tax benefits available to you through IRC section 1031 and section 121, you must be aware of the following hurdles.

The IRS has limited “first defer, then exclude” in at least five ways:

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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.

No matter how long you held the property as your principal residence, this is true.(IRC section 121(d)(6)

When the 1031 replacement property is a vacation home, the IRS limits the personal use of the property as follows: For the 24 months after you buy the property, in each 12-month period, you may make personal use of the property for the lesser of 14 days or 10% of the days the property is actually rented, at FMV, whichever is less. (Rev. Proc. 2008-16)

Note:These requirements are a “safe harbor.” This means that 1031 replacement properties that do not meet these parameters may still qualify for 1031 tax deferral.

One common question that we receive is if you can live in a 1031 exchange property after two years.

Under IRS Rev. Proc. 2008-16, a 24-month safe harbor exists. This means the IRS will not challenge the validity of your 1031 exchange if you hold your replacement property for investment for at least 24 months before conversion to a principal residence.

Any holding period of fewer than 24 months opens the taxpayer to challenge.

IRC section 121(b)(4) requires that, for any property acquired after 2009, the capital gains exclusion under section 121 reduces, pro rata, to the relative number of years it wasan investment versus a principal residence.

For example, an individual acquired a held-for-investment property in 2009. After three years, they converted the property to a principal residence.The property was a principal residence for five more years.Then they sell the property.They recapture 100% of the depreciation (see above). Since there was an eight-year holding period,they allocated the long-term capital gains, recognized 3/8th of the gain, and excluded 5/8th of the gain.(IRC section 121(b)(4).

IRC section 121(d) now sets a specific holding period when a 1031 replacement propertyconverts to a principal residence. That holding period is five years after the 1031 exchange.

For example, an individual buys a residential property as a 1031 replacement. After using the property as a for-rent vacation home for two years, the owner converts it to a principal residence.To qualify for ANY tax exclusion under IRC section 121, the taxpayer must convert to principal residence use hand hold for an additional three years (so the holding period is no shorter than five years). (IRC section 121(d))

Evenwith all these hurdles, applying IRC sections 1031 and 121 to real estate use can still work in taxpayers’ favor.

Suppose that, in 2022, you and your spouse use a 1031 exchange and buy an investment property in Miami — a lovelysingle-familyresidence. You rent out your replacement property for the next four years. After that, you retire and want to live near the beach. Lucky you, you have the Miami property, so you move into it. Six years later, you sell the Miami property.

When you first did your 1031 exchange in 2022, youdeferred$100,000 in capital gains taxes and $50,000 in depreciation recapture taxes.Tenyears later, your Miami property appreciated another $500,000 before you sold it.Your total capital gain, including the previously deferred amount, is $600,000 (plus you still have the $50,000 in unrecognized recaptured depreciation).

Normally under IRC section 121, a married couple filing jointly could exclude $500,000 of capital gains. However, since you converted this property from a previous 1031 exchange replacement property, you will not be able to exclude some of the gains based on how many years you rented the house.

You rented the house for four years out of ten years of ownership. Thus,you can exclude 40% of your capital gainsunder section 121.Youmust recognize $240,000 of capital gains (40% of $600,000),and you can exclude $360,000. You must alsoacknowledgethe $50,000 depreciation recapture from the old property.

Had youheld the property for 10 years instead of moving in, any sale would have triggered the immediate recognition of all $600,000 of taxes plus the $50,000 in recaptured depreciation.

Transferring a 1031 exchange requires careful attention to record keeping, including duration of use of the property and knowledge of tax rules, can still lead to a real estate transaction where tax exclusion follows tax deferral.

Please do not rely exclusively on the information contained in this article. These rules are complex and subject to other interpretations. It is always best to consult with a tax expert and 1031-qualified intermediary before attempting this strategy.