In order to qualify for non-recognition of gain under an Internal Revenue Code Section 1031 exchange (also called a like-kind exchange), both the property that you give up (the relinquished property) and the property you acquire (the replacement property) must be property held for productive use in a trade or business or for investment. This is sometimes referred to as the qualified purpose requirement.
By definition, your personal residence is not property held for investment or for use in a trade or business; therefore, it does not meet the qualified purpose requirement (although mixed use property may partially qualify – such as a duplex that you live in one unit and rent out the other or a home on the family farm). Thus, neither the relinquished property nor the replacement property in a 1031 exchange can be a personal residence. Also, holding a home simply with the hope that its value will go up does not constitute investment.
But what if your intentions change after you have acquired the replacement property? Is there a point at which you can move into the replacement property and convert it to your principal residence? And if you reside in it and own it the required periods of time, can you use IRC Section 121 to exclude up to $250,000 of gain ($500,000 for married persons filing jointly) on the sale of your principal residence?
It can be done, but the key is your intention at the time you acquired the replacement property. Did you honestly acquire it for investment purposes? Did you have a significant change in circumstances after the acquisition which caused you to move into the property? Can you prove your intention and that change in circumstances? If so, you may be able to re-characterize that 1031 exchange-deferred gain on investment property into gain on your principal residence and enjoy some or all of the $250,000 or $500,000 exclusion on its sale.
The principal question is your intent when you acquired the replacement property. If you sincerely intended to treat it as investment property and not to move into it at the first opportunity, then you are on the right track. How can you prove that intent? If you can’t meet the safe harbor test discussed below, the best way is to actually use the property for investment purposes for a significant period of time after its acquisition. If you rent the house out at fair market value for at least a year (according to some commentators), then you likely have shown you acquired the property with investment intent. If you merely put up a good show, on the other hand, such as listing it for rent at an amount that is significantly higher than market, or not even listing it at all, the IRS will see right through that.
Other common sense evidence of intent can be gleaned from a review of the case law (i.e., other people’s mistakes):
As mentioned above, the IRS has provided a safe harbor for determining how long a replacement property must be held as a rental before converting it into a primary residence or vacation home without invalidating the prior exchange. The replacement property must be owned for at least 24 months immediately after the exchange (the qualifying period) and in each of the two 12-month periods in the qualifying period: (1) the taxpayer must rent the replacement property to another person at a fair rental for 14 days or more; and (2) the taxpayer’s personal use of the replacement property must not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at fair rental. It can be rented to a family member as a principal residence so long as market rent is paid.
In order to qualify for the Section 121 exclusion of gain, you must use the home as your principal residence for at least 2 of the last 5 years prior to its sale. Also, Section 121 has a special rule for 1031 property that states that you have to own the home for at least 5 years (either as 1031 property or principal residence) before you sell it. Finally, the amount of the exclusion you can claim will be prorated between the period of time it was your principal residence and the time that it wasn’t, and any depreciation you took will be taxable.
This is an area where each person’s facts and circumstances are different, so before you get too far down the path of converting a 1031 exchange property to a principal residence, spend some quality time with your tax advisor.
This newsletter is for general information and education purposes only.
It is not offered as legal advice or legal opinion.
To the extent this message contains tax advice, the U.S. Treasury Department requires us to inform you that any advice in this letter is not intended or written by our firm to be used, and cannot be used by any taxpayer, for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Advice from our firm relating to Federal tax matters may not be used in promoting, marketing or recommending any entity, investment plan or arrangement to any taxpayer.