If you sell an investment property, you can get hit with a large tax bill, especially if you sell it for a large profit. However, a 1031 exchange allows you to use the proceeds from that investment property to buy another and defer any tax liability in the process.
The IRS stipulates that a 1031 exchange must be performed with two “like-kind” properties, which means that you have to sell one property you held as an investment in order to buy another property you plan to hold as an investment. So, in this sense, you cannot use a 1031 exchange to buy a primary residence with proceeds from an investment property.
However, there's no rule that says the newly acquired property must be used as an investment property forever. It's entirely possible to buy an investment property through a 1031 exchange, rent it to tenants for some time, and then move into the property yourself.
For example, let's say that you want to retire and move to the beach in a few years. You could sell an investment property that you currently own, buy a property at the beach using a 1031 exchange, and rent it out until you're ready to retire.
The capital gains tax exclusion for primary residences
Here's why this can be such a lucrative strategy. A 1031 exchange allows you to defer capital gains taxes until you sell the newly acquired property. However, if that property is a principal residence at the time you eventually sell it, you might be able to avoid some of your capital gains taxes permanently.
In most cases, when you sell an asset for more than you paid for it, you'll have a taxable capital gain. And as we've mentioned, this is typically the case when it comes to real estate.
However, if the real estate you sell was your primary residence, this isn't necessarily the case. The IRS allows you to exclude capital gains from the sale of your primary home, up to $250,000 for single taxpayers and $500,000 for married couples filing joint returns. For example, if you and your spouse acquired your primary residence for $300,000, you won't have to pay a dime of capital gains tax unless you sell it for net proceeds of more than $800,000.
To qualify for the primary residence exclusion, the property must have been owned and used as your principal residence for at least two of the five years before the sale. The ownership and usage requirements don't necessarily need to be met with the same two years, and there are exceptions that apply to active military personnel who have to relocate as part of their duties. And you can only use the exclusion once every two years.
3 Things you need to know before proceeding
Before you actually put a plan in motion to sell one rental property to buy one to eventually live in, there are a few rules you need to know. Specifically, lawmakers have taken steps to close this loophole, and while it still can be an effective tax strategy, it's not just an unlimited “pay no taxes” pass. The three most important rules you need to know before converting a property you acquired in a 1031 exchange into a primary residence are:
- Depreciation recapture cannot be permanently excluded
- Only some of your capital gains qualify for the exclusion
- You must hold the property for at least five years
Let's explore each of these in more detail:
Depreciation recapture cannot be permanently excluded
When you sell an investment property, there are two types of tax you might have to pay:
- Capital gains tax applies to the net profit you earn on the sale, relative to your cost basis in the property.
- Depreciation recapture occurs when you sell an investment property, as your cumulative depreciation you've claimed during your ownership period is considered to be taxable income upon the sale.
When you complete a 1031 exchange, you can defer both types of taxes. However, when you attempt to use the primary residence exclusion on a property you acquired through a 1031 exchange and later sold, you'll still have to pay any applicable depreciation recapture tax on both properties.
The short version: The primary residence exclusion only applies to capital gains, not depreciation recapture.
Only some of your capital gains may qualify for the exclusion
When you eventually sell the property after using it as a primary residence, you can only exclude capital gains that can be attributed to the time during which the property was used as your residence.
In other words, if you own a property for 10 years, but only used it as your primary residence for four, you can only use 40% of the capital gains toward the primary residence exclusion. And to make it a bit more complicated, any use prior to 2009 can be used toward the exclusion.
Consider this simplified example. Let's say you bought a property in 2005 for $100,000. You sell it in 2009 for $200,000 and use the proceeds to complete a 1031 exchange to a new property. In 2013, you move into the new property and live there for two years, selling it in 2015 for $300,000. This gives you a $200,000 total capital gain over a 10-year ownership period. You can consider the four years prior to 2009 as well as the two years you lived in the property for the capital gains exclusion (a total of six years). So, you can exclude 60% of your capital gains, or $120,000 from taxation. The other $80,000 will be considered a long-term capital gain and will be taxed accordingly.
It's also worth mentioning that any use after you live in the property can be considered for the exclusion. In other words, if you complete a 1031 exchange, rent the property for two years, live in it for three, and then rent it for another year before selling, you can consider four years of ownership toward the primary residence exclusion.
You must hold the property for at least five years
Here's the easiest of the three rules to understand. If you acquire a property through a completed 1031 exchange and use it as your primary residence, you must hold the property for at least five years after the exchange is completed. If you don't, you can't use the primary residence exception at all to exclude capital gains from taxes.
Defer to the professionals
As a final thought, it's important to point out (if it isn't already painfully obvious) that completing a 1031 exchange and then converting the property into your primary residence has some pretty complex tax implications. So, it's important to seek the assistance of qualified professionals to make sure you're doing everything right.
For starters, you'll need a qualified intermediary (QI) to facilitate the 1031 exchange. And you'll want the help of a tax professional or attorney with experience dealing with real estate investments (and preferably this specific type of transaction).
Whenever you're doing a transaction that can potentially allow you to avoid thousands of dollars in taxes, it's fair to assume that the IRS might want to take a closer look, so it's important to make sure everything is done right.