A 1031 exchange is used to buy and sell income-producing real estate and defer taxes. But what happens if you want to do a 1031 exchange on your primary residence?
While many investors think they can’t use their own home in a 1031, you actually can when you use enough planning and structure the transaction correctly.
Here’s how to perform a Section 1031 tax-deferred exchange using your primary residence.
How a 1031 Exchange Works
IRC Section 1031 allows real estate investors to relinquish or sell one property and replace it with another like-kind property and defer the payment of any capital gains tax that would normally be due.
Basic rules of a traditional tax-deferred exchange are:
- Relinquished and replacement property must be like-kind
- Real estate must be used for business or investment purposes
- Replacement property must be the same or greater value than the property relinquished
- Boot – either in cash or a cash-like benefit – can not be received by the investor
- Name on the title on the replacement property must be the same as on the relinquished property
- Replacement property must be identified within 45 days of the closing of the sale of the relinquished property
- Replacement property must be purchased within 180 days of the closing of the sale of the relinquished property
Normally the IRS does not allow you to conduct a 1031 exchange with your primary residence. That’s because the home that you live in isn’t being used as an investment property or being held for business purposes. Instead, your primary residence is used to provide shelter for your family.
However, there are some exceptions to this rule. IRC Section 121 of the Internal Revenue Code gives some situations where you can conduct a 1031 exchange using your primary residence.
Section 121 vs. Section 1031
Before we discuss in detail how to do a 1031 exchange on your primary residence, let’s talk about two things you can’t do:
- First, you can’t simply decide that your primary residence is a rental property and immediately turn around and use it as part of a 1031 exchange
- Second, you can’t live in your house and also claim that it is a rental property (unless you have a multi-family property, which we’ll discuss in detail later in this article)
Now, let’s review what you can do to use your primary residence in a 1031, and just as importantly how to go about doing it.
How to use Section 121
Section 1031 gives you a tax deferral on the payment of capital gains tax, Section 121 gives you a tax exclusion on the sale of your primary residence.
To meet the requirements of a Section 121 you must live in the primary residence for at least two out of the past five years.
What a Section 121 does
- Excludes tax
- Property used as a primary residence for at least two of the last five years
- Time used as a primary residence does not have to be concurrent
- Exclusion of $250,000 of gain for single filers and $500,000 of gain for married taxpayers filing jointly
- Section 121 may only be used once every two years
What a Section 1031 does
- Defers tax
- Relinquished property and replacement property must be like-kind and held for business or investment purposes
- All sales proceeds must be reinvested in order for tax on capital gain to be deferred
- Boot (cash or a cash-like benefit) received from the transaction is taxable as a capital gain
- All rules of the 1031 tax-deferred exchange must be adhered to, including the 45-day identification period and 180-day replacement period and use of a QI (qualified intermediary)
- No limit to the number of times a Section 1031 exchange may be used
Using Section 121 and Section 1031 together
- Section 1031: Tax-deferred exchange used for like-kind real estate held for business or investment use
- Section 121: Tax exclusion applies to a primary residence where the property has been used as a main residence for at least two of the past five years
- Split treatment: Use part of the property as primary residence and part of the property as an investment, such as a multi-family property where one unit is owner-occupied and the other units are rented out
- Section 1031 first: Acquire the rental investment as a replacement property in a previous exchange, then subsequently used a Section 121 to convert into your primary residence
- Section 121 first: Convert your primary residence into Section 1031 rental investment property
Converting a Primary Residence into a Rental Property
Let’s look at how to convert your primary residence into a rental property, using a small 3-unit multi-family property and a single-family house as examples.
Sale of a triplex (3-unit property) where you are living in one unit and renting the other two units out:
- One primary residence unit – use a Section 121 to convert to a 1031 rental unit
- Two rental units – use a Section 1031
- Use Section 121 to convert primary residence to a Section 1031
- Conduct a Section 1031 tax-deferred exchange to relinquish the single-family house and replace it with another like-kind property used for investment purposes.
Remember the rules
- Must live in the primary residence for at least two of the last five years before converting
- Can exclude up to $250,000 in capital gains if filing single and up to $500,000 in capital gains if filing jointly
- Section 121 may only be conducted once every two years
Converting a Rental Property into a Primary Residence
You can also do the opposite transaction and turn a rental property you currently own into your primary residence. For example, maybe you’d like to downsize and move into a smaller home, or relocate to a secondary market where the cost of living is lower and the quality of life is better.
If you already have rental property that was the replacement property for a 1031 exchange you previously conducted that you’d now like to turn into your personal residence. Believe it or not, the IRS allows you to do that, too.
But first, you have to prove to the IRS that you’re not trying to pull a fast one. In other words, you need to prove that your ‘intent’ when you acquired the replacement property (the property that is currently a rental) was to treat it as an investment property.
IRS Safe Harbor Test
The IRS has developed a safe harbor test for determining how long the rental property that you acquired as the replacement property with a previous 1031 tax-deferred exchange must be held before you can turn it into your primary residence. If you don’t pass the safe harbor test, you run the risk of the prior 1031 exchange that you used to acquire the rental house being invalidated:
- Qualifying Period: Replacement property must be held for at least 24 months after the exchange
- During each of the two 12-month periods in the qualifying period:
- Property must be rented to another person for at least 14 days at a fair market rent
- Personal use of the property may not exceed 14 days or 10% of the number of days the property was rented at fair market value during the 12-month period, whichever is greater
- Family or relative can be the tenant provided that they are paying a fair market rent
Other ways to prove you had the right intent
There are several ways to demonstrate that you had the right ‘intent’ when you bought the rental property that you now want to turn into your new residence:
- Use the property as a rental property with the rent at fair market value for at least 12 months or more
- Do not occupy the rental property after you acquire it, especially right after the exchange
- Purchase contract used to acquire the rental property as the replacement in your 1031 exchange should not be contingent on the sale of your primary residence
- Do not renovate the rental property as if you are going to move in right away, although making normal renovations to use as a rental property are acceptable
Single-family houses, multi-family property where you live in one unit and rent the other units out, and property you own and use as a short-term rental such as an Airbnb or HomeAway can all be used in a Section 1031 or Section 121.
You can use these two sections of the Internal Revenue Code to do a 1031 exchange on your primary residence, or to convert one of your current rental properties into your primary residence.
The key factor to keep in mind is that you need to turn your primary residence into your former residence, and then proceed with your 1031 tax-deferred exchange to relinquish one property and replace it with another investment property.