A 1031 exchange can be a great way to defer taxes on the sale of an investment property. But primary residences aren't typically eligible. You usually need to sell one rental property and buy another as an investment.
However, there’s one loophole that lets you sell an investment property and buy another property that will eventually become your primary home. And you can take advantage of the huge tax benefit available on its sale. Here’s a rundown of how this could work.
How a 1031 exchange typically works
A 1031 exchange, or “like-kind exchange,” lets real estate investors defer taxes on the sale of an investment property.
If you sell one investment property and use the proceeds to buy another, you can defer paying capital gains and depreciation recapture tax on the sale. Of course, it's more complex than this -- check out our guide to 1031 exchanges for more details. But that's the basic idea.
A 1031 exchange generally only involves investment properties. Your primary residence isn't typically eligible for a 1031 exchange. Even a second home that you live in some of the time is ineligible if you don't treat it as an investment property for tax purposes.
Consider this scenario
Let’s say you want to move somewhere else or downsize your current living situation eventually but aren’t ready to just yet. For example, let’s say you want to retire in a few years, and that you’d like to move into a beach condo.
If you’re a rental property investor, there's an interesting 1031 exchange strategy you might be able to use.
Here’s the basic idea. You own an investment property that, if sold, would result in a substantial capital gains tax bill. By selling it, buying the property you want to live in, and renting it out in the meantime, you could eventually move into the property and convert it to your primary home.
Why this can be a smart tax strategy
The reason this can be such a lucrative strategy is the primary residence exclusion for capital gains taxes.
When you sell a primary residence, you can exclude as much as $250,000 of capital gains from taxes. Keep in mind that the IRS defines a primary residence as a home you’ve lived in full-time and owned for at least two of the previous five years. Married couples get to double this -- up to $500,000 can be excluded.
Consider this example. Let’s say you bought a rental property for $100,000 15 years ago and you expect it to sell for $250,000. By using the sale proceeds in a 1031 exchange to buy your future primary home, you could effectively defer the $150,000 in capital gains indefinitely. And you could exclude them from taxation if you sell the second property.
With a typical 1031 exchange, you can defer capital gains taxes on the sale of a property. You’ll still need to pay them eventually. But using this method, you convert the acquired property to your primary home. And you can avoid paying some of your capital gains tax entirely.
Rules to know
Like any tax “loophole,” using a 1031 exchange in this way has rules, limitations, and other things you should know.
For starters, you’ll have to set up the 1031 exchange properly, including the use of a 1031 exchange facilitator. With a 1031 exchange, it’s important the process is done in strict IRS compliance.
While you can avoid capital gains taxes through the primary residence exclusion, you cannot use the exclusion for depreciation recapture taxes. The depreciation deductions you took while the original and replacement properties were still being treated as investment properties will be taxable when you eventually sell.
There’s also a rule that requires you to split the capital gains between your investment and primary home usage for the primary residence exclusion. Imagine that you owned the property as an investment for seven years and as a primary residence for three. Only 30% of the deferred capital gains could be excluded upon the sale of your primary home. Under this rule, investment use prior to 2009 is still excludable -- you just have to prorate your capital gains exclusion for 2009–present.
The previous two rules apply for any investment property you convert to a personal residence. But there’s a special rule that applies in the case of a 1031 exchange. If the primary home was acquired as part of a 1031 exchange, you have to hold it for a minimum of five years after the exchange was completed to exclude any capital gains from taxation.
An example scenario
To tie all of these rules together, let’s take a look at a thorough example.
Let’s say that you and your spouse bought an investment property in January 2005 for $150,000. You sold it in 2011 for $250,000 and completed a 1031 exchange, buying a beachfront condo for $400,000 with the proceeds and some of your own cash. So you’ve deferred $100,000 of capital gains.
You rent the condo out for three years and move into it at the beginning of 2014. If you sell the condo at the end of 2018 for $600,000, here’s how the tax scenario would play out:
- You would have a total of $350,000 in capital gains -- $150,000 carried over from the 1031 exchange and $200,000 from the profit on the sale of the condo.
- You would exclude the capital gains taxes from 2009 through 2013 but could include 2005–2008 (before that rule applied) and the period from 2014–2018. Adding this up, this is five years of non-qualified use and nine years of qualifying use.
- Although the $350,000 of capital gains is within the $500,000 maximum, you can only exclude about 69% of it from taxes (nine out of 14 years of ownership).
- The end result is that you can exclude $241,500 of your capital gains, but you must report $108,500 of it to the IRS. Since you owned the property for over a year, it's treated as a long-term capital gain.
- All depreciation deductions you took for both properties while they were investments are taxable under the depreciation recapture rules.
Do your homework and seek professional advice
1031 exchanges are complex enough. If you plan to eventually use the property you acquire in a 1031 exchange as your primary home, it adds another layer of complication. Be sure to check with a real estate lawyer or other professional with extensive experience in these types of situations. They'll help ensure that you’re 100% compliant with IRS rules and regulations at every stage of the process.
And when it comes time to sell the investment-property-turned-primary-residence, be sure to talk to a tax attorney or other qualified professional. They'll make sure you pay all the required tax as part of the sale -- but not a penny more.