As we’ve mentioned several times before here on the blog, you are able to only make a 1031 exchange on property you hold for business or investment purposes. Properties that are held exclusively for personal use cannot be included as a part of a 1031 swap. Also, the primary residence will not generally be considered as a qualifying property for an exchange of like-kind.
Consider, for example the case of if your goals alter after you’ve acquired the property you are replacing? Is there a date that you could transfer to the replacement property and make it your primary residence? If you live in it and have it for the necessary timeframes could you make use of IRC Section 121 to exclude the gain of up to $250,000 ($500,000 for married people who file jointly) from the sale of your primary residence? This is possible however the most important thing is what you intend to do when you bought the property you are replacing.
Guidelines For Converting The 1031 Exchange Property Into A Principal Residence
The main issue is what was the purpose you were going to have when you bought the property replacement. If you really wanted to use it as an investment property, and not relocate to it at any time and you’re on the right path. How do you prove this intention?
If you’re not able to pass the test for safe harbor that is discussed in the following paragraphs, the best option is to utilize the property to invest in for a long amount of time following the purchase. If you let the property out at the fair market price for at minimum a year (according to 1031 experts) If you do, then you have proved that you purchased the property for investment purposes.
A different common-sense indication of intent is gleaned from a study of cases (i.e. mistakes made by others): mistakes):
Don’t make plans for your primary home or vacation property in the days prior to or after the exchange.
Don’t make the move immediately following the exchange, even if you are only there for a short period.
Do not make the agreement to purchase the new property contingent on the sale of your primary residence.
Utilize a sensible and substantial quantity of advertisements or listings to let the property for an affordable rental.
Note how you arrived at the price you would like to pay for the rent.
Record all efforts that you make to rent the property out, including the names and contact details of potential tenants who have visited the property. It is possible to need to call witnesses!
If you experience an event which led to you moving into the home, be sure to record it. Did you suddenly lose your job, fall ill or disabled, divorced, getting married, or house the elderly parents of your family?
The past was when taxpayers were able to be able to convert their home into renting the property for a time before moving into it, then exempt all or a portion of the gain from Section 121. If they lived in the property as their principal residence for at least the period of two years, taxpayers can sell it and deduct the gains under Section 121, up to a maximum amount of $250,000 or $500,000. In the past, Congress amended Section 121 to restrict benefits offered by Section 121 when the property is also being utilized as an investment property.
In the first instance, if you purchase property through the 1031 exchange, and later transform it into your principal residence, you have to be a homeowner for at least five years prior to becoming eligible for the Section 121 exemption.
The second reason is that any gain you are able to exclude will be diminished to the extent the house was used as purposes other than primary residence in the time of ownership. The exemption is reduced proportionally ratio by comparing the amount of years that the property was utilized for purposes other than primary residence to the total amount of time the property is held through the taxpayer.
A couple who are married use a tax-deferred exchange within Section 1031 to purchase an investment property such as a home. The couple leases the property for three years and later moves into it and use it as their main residence for the next three years. The couple sells the house at the close of the year 6 and realizes an income of $800,000. Instead of being able remove $500,000, they are unable to keep a portion of their gains based on the number of years they had rented the property. As they rented the property for three out of six and a half from the gains, which is $400,000, won’t be exempt. Due to this new restriction it means that the couple will only be capable of excluding $400,000 of the gain, rather than $500,000.
Exclusivity
However there are a few exceptions to this limitation. If the property was being used as a rental before January 1st of 2009 The exclusion will not be affected. Based on the example above in the case of a three-year rental period began prior to January 1st, 2009, exclusion will not be diminished and the couple will be able to exempt the full amount of $500,000.
Another notable exception is that property initially utilized to be a residence primary, and later changed to an investment property isn’t restricted by the rules in excluding gains. In other words If you live in a residence for 18 years, but you decide to move out and rent the property for two years prior to selling it, you will get the entire amount of the exemption.
The Final Words
In essence the 1031 exchange allows you to swap an existing business or investment property for a house that you later transform into your primary home. Of course, you’ll need to keep the property an investment for a certain duration of time to fulfill the requirements of Section 1031 , but with a bit of planning and a little perseverance, you may soon be living in the home of your dreams, but be sure to plan your exit strategy prior to making a decision.
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