Can You Live in a 1031 Exchange Property

Final updated on October 1, 2021

A 1031 exchange is used to buy and sell income-producing real estate and defer taxes. But what happens if yous desire to do a 1031 exchange on your primary residence?

While many investors remember they can't use their ain home in a 1031, you actually tin can when yous use enough planning and construction the transaction correctly.

Here's how to perform a Section 1031 revenue enhancement-deferred exchange using your primary residence.

How a 1031 Commutation works

IRC Section 1031 allows real estate investors to relinquish or sell one property and supersede it with some other similar-kind belongings and defer the payment of any majuscule gains tax that would normally exist due.

Basic rules of a traditional tax-deferred exchange are:

1. Relinquished and replacement property must exist like-kind
2. Real estate must be used for business or investment purposes
3. Replacement property must be the same or greater value than the holding relinquished
4. Boot – either in cash or a cash-like benefit – can not be received past the investor
5. Name on the championship on the replacement property must be the same as on the relinquished property
6. Replacement belongings must be identified within 45 days of the closing of the sale of the relinquished property
7. Replacement property must be purchased within 180 days of the closing of the sale of the relinquished property

Usually the IRS does non let you lot to carry a 1031 commutation with your chief residence. That's because the habitation that you live in isn't being used as an investment holding or beingness held for business organization purposes. Instead, your primary residence is used to provide shelter for your family unit.

Yet, there are some exceptions to this dominion. IRC Section 121 of the Internal Acquirement Code gives some situations where you lot 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 main residence, allow's talk near ii things you lot can't do:

• First, you can't simply decide that your primary residence is a rental holding and immediately turn around and employ it as part of a 1031 exchange
• Second, you tin can't live in your house and besides merits that information technology is a rental property (unless y'all have a multi-family unit property, which we'll discuss in detail later in this article)

Now, permit'southward review what you tin can do to utilize your primary residence in a 1031, and simply every bit chiefly how to go virtually doing it.

How to use Department 121

Department 1031 gives you a tax deferral on the payment of capital gains tax, Department 121 gives y'all a tax exclusion on the auction of your primary residence.

To run across the requirements of a Section 121 you lot must alive in the primary residence for at to the lowest degree two out of the past v years.

What a Section 121 does

• Excludes taxation
• Holding used as a primary residence for at least two of the last v years
• Time used as a primary residence does not take to be concurrent
• Exclusion of $250,000 of proceeds for single filers and $500,000 of gain for married taxpayers filing jointly
• Section 121 may just exist used once every two years

What a Section 1031 does

• Defers tax
• Relinquished holding and replacement property must be like-kind and held for business organization or investment purposes
• All sales proceeds must be reinvested in order for tax on uppercase proceeds to be deferred
• Kicking (cash or a cash-similar do good) received from the transaction is taxable as a capital letter gain
• All rules of the 1031 revenue enhancement-deferred exchange must be adhered to, including the 45-day identification menstruation and 180-twenty-four hours 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 substitution used for similar-kind real manor held for business or investment employ
• Department 121: Tax exclusion applies to a primary residence where the holding has been used every bit a main residence for at to the lowest degree two of the past v years
• Split treatment: Employ office of the property equally primary residence and part of the belongings as an investment, such equally a multi-family unit property where i unit of measurement is owner-occupied and the other units are rented out
• Department 1031 starting time: Acquire the rental investment as a replacement property in a previous exchange, and then later on used a Section 121 to convert into your primary residence
• Department 121 first: Convert your primary residence into Section 1031 rental investment property

Converting a principal residence into a rental holding

Let's wait at how to convert your primary residence into a rental holding, using a small 3-unit of measurement multi-family unit holding and a single-family unit house equally examples.

Multi-family unit property

Sale of a triplex (3-unit holding) where you are living in one unit and renting the other two units out:

• One primary residence unit – use a Section 121 to catechumen to a 1031 rental unit of measurement
• Two rental units – apply a Department 1031

Single-family unit property

1. Utilise Section 121 to convert primary residence to a Section 1031
2. Conduct a Section 1031 taxation-deferred substitution to relinquish the unmarried-family house and supervene upon it with another similar-kind belongings used for investment purposes.

Remember the rules:

• Must live in the main residence for at to the lowest degree two of the concluding five years before converting
• Can exclude upward to $250,000 in capital gains if filing single and up to $500,000 in uppercase gains if filing jointly
• Section 121 may just be conducted once every two years

Converting a rental property into a primary residence

You can also do the opposite transaction and plough a rental property you currently own into your main residence. For instance, maybe yous'd like to downsize and move into a smaller dwelling, or relocate to a secondary marketplace 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 y'all previously conducted that you'd at present like to plow into your personal residence. Believe it or not, the IRS allows y'all to do that, too.

But get-go, you have to bear witness to the IRS that y'all're non trying to pull a fast one. In other words, you need to prove that your 'intent' when you acquired the replacement property (the belongings that is currently a rental) was to treat it as an investment belongings.

IRS Safe Harbor Test

The IRS has developed a safe harbor test for determining how long the rental property that yous acquired as the replacement holding with a previous 1031 taxation-deferred exchange must be held earlier you tin turn it into your primary residence. If you don't pass the safe harbor exam, you run the take a chance of the prior 1031 exchange that you lot used to acquire the rental business firm being invalidated:

• Qualifying Period: Replacement property must exist held for at to the lowest degree 24 months after the exchange
• During each of the two 12-calendar month periods in the qualifying period:

• Property must exist rented to another person for at least 14 days at a off-white market rent
• Personal use of the property may not exceed xiv days or x% of the number of days the property was rented at off-white market place value during the 12-calendar month period, whichever is greater
• Family unit or relative can be the tenant provided that they are paying a fair market hire

Other ways to prove yous had the correct intent

At that place are several means to demonstrate that you lot had the right 'intent' when you bought the rental holding that you now want to turn into your new residence:

• Use the property as a rental property with the rent at fair marketplace value for at least 12 months or more than
• Do not occupy the rental property afterwards you acquire it, specially right after the exchange
• Buy contract used to acquire the rental property as the replacement in your 1031 exchange should not exist contingent on the sale of your principal residence
• Do not renovate the rental property equally if you are going to move in right away, although making normal renovations to use as a rental belongings are acceptable

Final thoughts

Single-family unit houses, multi-family property where you live in one unit and rent the other units out, and belongings you lot own and use as a short-term rental such as an Airbnb or HomeAway can all be used in a Section 1031 or Department 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 backdrop into your primary residence.

The key factor to keep in heed is that you need to plough your primary residence into your sometime residence, and so keep with your 1031 revenue enhancement-deferred exchange to relinquish i property and supplant it with some other investment holding.

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Source: https://learn.roofstock.com/blog/1031-exchange-primary-residence